A CFD or a Contract for Difference by definition is a contractual agreement between two parties to pay the difference in the value of an underlying asset from the time the contract is opened to the time that it is closed. For example, if the value of the underlying asset rises in value, the buyer of the contract will the receive increase in value from the seller of the contract. The reverse is true if the value of the underlying asset falls in value. Because CFDs can be traded on margin, this gives the trader more leverage with his investment capital.
Trading Contracts for Difference
So what is CFD trading all about? For many traders CFDs, Contracts for Difference, represent an alternative way of trading the financial markets. A trader can trade on the movements of stock prices without having to actually own the stock. They are not just limited to stocks. In fact, they cover a whole range of asset classes such as currencies, commodities, indices and even treasury bonds.
When trading in this instrument, a trader is not dealing with the actual asset per se. What he is dealing with is actually a financial instrument or derivative whose value is based on the price of the asset or what is termed as an underlying asset. The CFD trader will buy or sell units of this instrument depending on whether he thinks the price of the underlying asset will rise or fall respectively.
There are many providers of CFD trading platforms. However these are the most popular CFD brokers:
For argument sake, let’s say you think that the price of Facebook’s stock will rise from its current price of $100. You decide to invest $1000 into Facebook’s stocks in order to profit from this rise. Traditionally to benefit from the rise in the stock’s price, you will need to purchase the stocks itself. With your $1000 investment capital, this means you can only purchase 10 shares. So if the price of Facebook’s stocks rise to $110, this means you will earn a gross profit of $100 ($10 rise x 10 shares)
However trading CFDs, a trader stands to earn more with his $1000 investment capital. This is because he can trade on a margin ranging from 10% to 20% depending on the broker. Suppose the margin required by the broker is 10%, this mean his $1000 capital will allow him to carry out a transaction worth $10,000. In other words, he can buy CFDs equivalent to 100 shares. So with a $10 rise in the stock value, his gross profit will actually be worth $1000 ($10 x 100) - a 100% return on his investment.
CFDs have become popular among online traders over the past few years largely due to their use as a hedging tool especially for those with a large equity position. With no expiry dates and high leverage provided by brokers, traders now have a cost effective way of protecting the value of their investments with just a notional exposure.
With the low transactional cost involved in CFDs trading, this instrument also is an ideal tool for diversifying one’s investment portfolio. Traders can now take up multiple positions with a minimal capital outlay.
Because of the way CFDs are structured, they are also popular among traders as a means to scalp the markets. The high leverage and low cost of transactions let traders take advantage on any small rise in the value of the underlying asset.
Since CFDs are a leveraged product they can result in substantial gains for the trader. However, they can also result in substantial losses and even the loss of the entire capital involved in the transaction. That’s why trading this instrument must be done with caution and with an understanding of the risk involved.
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Please be aware that trading the financial markets is one of the riskiest investment forms possible and may result in substantial losses.