If you’ve spent any time looking at the financial markets, you might have come across the term CFD. Known in full as contracts for difference, these are a type of financial derivative available from online brokers, which are used by traders aiming to make a profit from the difference between opening and closing trade prices of any asset. Although some terminology might sound complex to a beginner, this article will attempt to illuminate the world of CFDs, and help you decide whether you want to use them.
Understanding CFDs
A derivative refers to a financial investment derived from underlying assets and securities. CFDs are essentially used by traders and investors to place bets on the price movements of the underlying security or asset; betting on whether it will rise or fall. CFD traders can place a bet that the price will either move upwards or downwards. Traders will buy a CFD when they expect upward movements in price, while on the other hand, traders who believe the price will fall might open a sell position.
Transacting in CFDs
CFDs can be used for trading in a wide range of securities and assets, including forex, stocks, and even crypto. Traders can also use CFDs for speculating on the movement of prices of commodities like crude oil or wheat. CFDs are traded over-the-counter rather than on major exchanges such as the London Stock Exchange or New York Stock Exchange. CFDs are tradeable contacts between clients and brokers, who exchange the difference between the trade’s initial price and where its value stands once the trade is reversed or unwound.
Advantages of CFDs
CFDs have all the advantages and risks of security ownership without the need to actually own or take physical delivery of the asset. Brokers often allow investors to borrow money to increase the position leverage or size, which is referred to as trading on margin. Typically, brokers will require that traders are able to maintain a certain account balance before a transaction of this type will be permitted. Compared to traditional trading, another benefit of trading on margin CFDs is that it usually provides higher leverage. In addition, the regulations and rules that surround the CFD market tend to be fewer and less stringent compared to other exchange types. Because of this, CFDs often have lower capital requirements and traders may be able to open an account with a broker or CFD trading platform for a low minimum amount.
Disadvantages of CFDs
Contracts for differences, although simple to execute, require good market knowledge and are typically used by more advanced and experienced traders. The learning curve to using them effectively can be steep. The underlying asset may experience high price fluctuations or extreme volatility, which can lead to a significant spread on bid and ask prices. This prevents traders from making a profit from small CFD movements, which ultimately reduces the number of winning trades and increases losses.
CFDs offer an alternative type of trading that allows investors to experience all the benefits and risks of security, without actually owning it. In summary, if you’re thinking of getting involved in CFDs, make sure you do as much research as possible on how to use them responsibly, understand the asset you’re trading, and follow risk management best practices to limit your potential downside.