Contract for differences (CFDs) is a popular alternative to spread betting, allowing traders to pursue potentially profitable opportunities in a range of asset classes, including currency pairs, commodities, and stocks.
While CFDs open a world of opportunity and provide the potential to turn a profit during a bear market, they can carry a significant risk if you’re unfamiliar with how they work.
Here’s more information about CFD trading and how it works.
A CFD is a contract traded on the market representing the agreement between an investor and financial institutions to exchange a certain asset’s price difference. It is a financial derivative product based on an asset’s value, such as the price of an individual share, currency, or commodity.
The contract usually involves an investor and a spread betting firm or investment bank and often lasts for days or weeks.
Compared to the risk associated with investing in typical stocks and shares, trading CFDs puts you at more risk of turning and losing a profit, making it more similar to gambling than investing.
CFDs are an attractive product to currency and commodity traders in particular. That’s because traders don’t need to buy the underlying asset, like a stock or commodity, since CFDs are a derivative. Instead, they have access and exposure to the price movements associated with the security in question.
Once the contract ends, the two parties exchange the difference between the opening and closing prices of the asset involved.
The Appeal of CFDs
CFDs’ ability to help traders predict whether an asset’s price would go up or down makes them an attractive investment. Whether you win or lose will depend on the accuracy of your forecast.
A market player will buy a CFD or ‘go long’ if they believe the asset’s price will climb, while they will sell or ‘go short’ if they think the price will drop.
You can profit or lose from either method depending on how the asset’s price will move.
Going Long vs. Going Short
In conventional share dealings, purchasing stock is the only option you have. CFDs, on the other hand, let you buy and sell assets that you believe will decline in value.
Going short with such a derivative product works similarly to going long. However, instead of buying contracts to open a position, you’re selling them. That way, you open a trade that makes money, provided the main market dips but posts a loss if it increases.
CFD markets have two prices. You have the buy or ‘ask’ price and the sell or ‘bid’ price. If you’re looking to open a long position, you need to trade at the buy price. If you want to go short, you should trade at the sell price.
To close the position, you need to place a trade opposite the one that opened it.
Trading CFDs Explained
Instead of buying or selling the underlying asset, CFD allows you to buy or sell units in a financial instrument linked to the main asset. CFD providers like spread betting companies usually offer access to different markets, including currencies, commodities, stock indices, and shares.
As a CFD trader, you decide how many contracts you want to purchase or sell instead of how many of a certain asset you want to own.
You make money when the market moves in your favor and incur a loss if it moves against you. The profits and losses are realized once you close a position and the contract bought at the start of the bet is sold.
Furthermore, the return you receive in trading CFDs is determined by your position size and the number of points the market involved has moved.
As CFD trading focuses on price movements, there is no stamp duty to pay since you don’t physically own the underlying asset. Spread betting is also exempted from the capital gains tax, as it can be seen as gambling.
The Risk of Trading CFDs
CFDs are a leveraged product that lets you open a position by only paying a small percentage of the total value, more commonly known as margin trading.
Simply put, a first-time trader only needs a small capital to make a bigger investment. Such a method raises the potential returns, but it also raises the potential losses.
So instead of the cost of the first bet, the trader who made the wrong call may lose all the money they have put into an account with the CFD provider.
Moreover, CFD trading can be riskier than conventional share trading, making it suitable only for certain investors. With CFDs, you’re also running the risk of facing a partial or complete loss of capital.
Understanding Margins Further
Margin refers to the capital required in a trader’s account to open or maintain a leveraged position. It represents the percentage of the overall trade size, and the amount required differs in every market.
In the currency market, CFD traders may need to have 5% of the total value in their accounts. Shares might require between 25% and 30% of the trade size.
The Purpose of CFDs
With CFDs, traders are able to hedge their portfolios, protect against unfavorable price movements, or make money from market declines by taking short positions.
In hedging risk, CFD traders may be planning to lock in the value of the share portfolio at a particular time. So, for example, if you have a share portfolio that reflects the performance of the S&P 500, by selling S&P 500 CFDs, you can lock in the portfolio’s value at that point in time.
If the index stumbles after CFD is sold, the stock portfolio will also slide, but losses incurred by your share portfolio will be offset by the profit made by the index CFD position.
Conversely, the stock portfolio and the CFD position will advance should the index trades higher. The gains in the value of the shares would now offset the losses generated by the CFD trade.
In that way, you can protect your share exposure without liquidating your current holdings.