A contract for Difference (CFD) is a type of derivative trading that has become popular. Instead of owning the instrument of the trade, you are speculating on the price movement of a number of financial markets, such as shares, currencies, commodities, indices and bonds. There are many advantages to speculating on whether the price will rise or fall, instead of actually owning the underlying instrument and for this reason, CFD trading has become an attractive option for many people.
How CFD Trading Works
When CFD trading, you never trade in the underlying asset itself. Rather, you buy or sell a number of units of the instrument and if the price of the instrument moves in your favor, you make a profit. In the same way, for each point the price moves against you, you experience a loss. The amount you make or lose is determined by the number of CFD units you bought or sold. When trading CFDs, it’s generally possible to use one broker who will offer products in all of the major markets making it simple to trade any market that is open from a single platform. Trades are made through brokers and it is important to note that the CFD industry is not highly regulated and that you need to look into the reputation and credibility of a broker before you begin trading.
Understanding Leverage and CFD Trading
One of the factors that make CFDs attractive is that they are a leveraged product. Also called trading on margin, this means that you only need to have a small amount of capital to open a position. This can lead to much greater returns, although on the flip side, losses can be greater as well.
Hedging Your Portfolio
Some people use CFD trading as a way to hedge their physical portfolio. In other words, if you have a portfolio with physical shares and it looks like they will lose value over the short term, you can hedge your shares by using CFDs. If you short sell the same shares as CFDs, you can make some profit in the short term as a way of offsetting your losses from your portfolio.
Understanding the Spread
There are commonly no fees for trading a CFD, meaning that often brokers will not charge a fee or commission for you to enter or exit a trade, but, as the trader, you will need to pay the spread. In other words, to buy you will need to pay the ask price and to sell you will need to pay the bid price. This spread can be small or large. It is important to understand this because it means that if you would have profited from small moves, the spread may eliminate your profit.
The Final Say
There are many advantages to CFD trading that have made it an attractive option and alternative for many people. However, it is important to understand how it works so you’re aware of its disadvantages as well before you begin trading.