CFDs is an acronym for Contract For Difference. It’s a means by which you can trade different financial instruments (the underlying market) and hopefully benefit from the difference in price in which you open a trade versus that of the price you close a trade.
CFD’s were initially developed in the early 1990s in London as a type of equity swap that traded on margin.
Essentially, CFDs in the simplest term, it’s a ‘contract’ between a buyer and a seller which represents the difference between the price when you buy and sell a CFD of a share, index or commodity.
It’s become a very popular financial tool for many traders. It allows them to buy and sell a contracted number of shares in a stock they chose, at a certain price, for any period of time. There is no physical delivery of a CFD contract nor are their additional benefits of owning a share such as attending the AGM.
What are the benefits of CFD Trading?
Trading with CFDs can give you a range of advantages, so it’s viewed as very flexible:
- Trading on margin (leveraged position)
- The ability to go long or short
- The ability to hedge
- Flexible contract sizes
The money earned with CFD trading flows into or out of your account depending upon the success of your trading.
Here’s a simple example of how it works hypothetically:
Open Position: Buy 1 Share = $400 (Company share + 1)
If you were to buy into that position (also known as; going along in the market/going long) and the price of the company’s shares went up by $100, and you decided to sell the position (going short), the example below shows the profit.
Close Position: Sell 1 share = $500 (Company share + 1)
Profit = $100
Are CFDs risky?
Doesn’t that example look great? But like all investments, there is a level of risk and CFD trading is considered high risk, especially if you are a newbie and are unsure how to manage and mitigate your risk. The FCA has been over recent years applying stricter rules on CFDs. Reputable CFD providers will clearly state at the top of their pages a disclaimer, such as the popular platform Trading 212, which states:
CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 76% of retail investor accounts lose money when trading CFDs with this provider. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.
What is an underlying asset?
The underlying asset is the price of a CFD stemmed from a physical asset in the market. Either shares, indices, commodities or stocks and now cryptocurrencies.
The price of the CFD will mirror the price of the underlying market. It’s good to know that CFD traders do not trade or own the underlying asset. CFD trades simply involve betting on the future price of a particular asset. CFD trading platforms offer a wide range of underlying markets. All CFD have a product disclosure statement. A reputable provider will have detailed information on costs, markets, and trading examples, as well as highlighting the risks of CFDs.
There is risk when trading CFDs and there are common mistakes beginners make, such as, not having and sticking to a trading plan/strategy, not using stops and sometimes being too greedy. Whilst costly mistakes can be made, there are fundamental elements of trading CFDs, that make it attractive to experienced traders that can afford the gamble – it’s called Leverage or Margin.
Also read: Understanding Contracts For Difference and the common mistakes for beginners
What is Leverage
Leverage is a double-edge sword; leverage allows you to gain access to the value of a position that is far greater than the amount you have in pounds in your trading account.
Essentially, you use a percentage of your money with your CFD provider ‘lending’ you the remaining amount, so it’s like when you open a trade, you are placing a deposit of the total value of the trade.
This is called a leveraged position.
What does this look like? You put in 10% of your own money to open a trade of the market value, the CFD provider makes up the 90%, the benefit is you are entitled to the GAIN as if you had paid 100%. However, if the trade is unsuccessful you are responsible for the LOSS as if you had paid 100% too.
Different CFD providers will ask for different percentages. Even though you are learnt this money you are always responsible for the full value of the trade.
This is fine for those with experience who can risk big on some of the trades they are taking, however, you can lose a lot of money if the trade doesn’t go according to plan.
It’s important to manage your risk exposure for every trade, and learn how to mitigate risk and some of the large fluctuations.
Also read: CFDs vs FOREX