Contract for Differences (CFDs) are interesting investment vehicles. Although many investors are not currently using them in the mainstream, CFDs have become a very popular financial product among online traders.
CFD trading is a great way to make money from financial markets, but it can be a little daunting for the beginner. This article will discuss what CFD trading is and how it works.
What is CFD Trading?
A CFD is an agreement between a CFD broker and an investor to exchange the price difference of a financial product between opening and closing a trade position. CFDs allow investors and traders to profit from an asset’s price movement without owning the asset.
The value of a CFD contract has no relation to the underlying asset’s value but only to the price difference between the entry and exit of the trade. This is because a CFD trader does not own the asset but receives revenue based on the price fluctuations of the asset.
CFD trading allows investors to speculate on the prices of financial assets. However, instead of investing in the asset, traders buy a contract. The contract allows the trader to earn the price difference of an asset from when they open the trade to when they close it.
Advantages of CFD Trading
- Low fees and commissions: Trading in CFDs has lower fees than purchasing stocks. Additionally, most CFD brokers don’t charge fees for opening and closing positions.
- Easy to execute: Most CFD platforms allow traders to open and close trade positions instantly. Investors and traders, therefore, have instant access to their capital. Traders also have more trading opportunities because they can quickly react to market conditions.
- Ability to trade on long and short positions: In a long trade position, an investor will profit when the underlying asset price rises. On the other hand, the investor will profit when the price falls in a short trade position. Short positions allow investors to take advantage of stocks that they think are overvalued.
- Trade using leverage: Leverage allows traders to control large trade positions with a small amount of capital. Traders are therefore able to make larger profits from small market movements.
Disadvantages of CFD Trading
- Leverage: Leverage can make investors earn huge profits from a small amount. Consequently, the same leverage can result to huge losses if a price prediction moves against you.
- High risk: CFDs are much riskier in dealing with compared to dealing in shares directly. In case there is a slight drop in the asset’s value, the leveraged capital magnifies the drop.
- Risk of overtrading: CFDs offer a low-cost method of accessing the market since of their lower capital requirements. Because of these, many traders risk overtrading. Overtrading is a situation where a portfolio is over-exposed to the market risks, such that the remaining capital is insufficient to cover losses.
- Lack of ownership: In CFD trading, you don’t own any assets other than the contract. There is, therefore, no intrinsic value aside from the current market price. If you own an asset, you can hold it for the long term if the current price is unfavorable.
How Does CFD Trading Work?
Trading CFDs is similar to trading other products in the financial markets, such as stocks, commodities, and currencies. CFD traders buy and sell a specific amount of their preferred asset, and the buying and selling price dictates their profit or loss.
However, CFD traders trade in contracts that mimic the live prices of stocks, commodities, and currencies instead of trading in stocks, commodities, and currencies.
For example, A Tesla CFD will track the share price movements of Tesla. Buying 100 Tesla CFDs is equal to buying 100 Tesla shares. If every Tesla share moves up by 1 U.S Dollar, you earn 100 U.S Dollars. Similarly, if each Tesla share falls by 1 U.S Dollar, You lose 100 U.S dollars.
A CFD market has two prices; the selling price and a buy price. The difference between the prices is referred to as a spread. On long positions, you open at a buy and close at a sell. On short positions, you open at a sell and close at a buy.
CFD trading is a fast-paced, exciting industry that offers the opportunity to make large amounts of money. However, it can be a challenge to get started. Additionally, understanding CFD trading requires specialized knowledge and skills. If you’re considering becoming involved in this trade, make sure you read through our complete guide on CFD trading.