What are CFDs?
A CFD, or Contract for Difference, is a financial derivative traded on the financial market. Technically it is a contract speculating on the direction the asset price movement, made between the trader and a dealer or broker. No actual assets are traded, but rather a contract on the asset price.
It allows an investor to take advantage of price movements of a financial asset without actually having to acquire the underlying asset. This provides an avenue for investors to invest in the financial markets at a lower cost since there is no requirement to physically own the asset.
CFDs are offered for a variety of financial asset groups. Particularly popular are CFDs on commodities, such as oil, coffee, wheat, sugar gold and other precious metals etc. The trade in commodities is usually problematic for the individual trader because the ownership of this type of asset evolves storage and transportation. CFDS present a convenient solution.
In the past years, other assets have become popular as well. CFDs on stocks, indices, and even currencies are commonly offered on financial platforms nowadays.
How CFDs trading works
Once you understand the principle, it is very simple. You chose an asset for which you believe the price will move either upward or downward. If you expect the price to increase you choose what is called a “long position”. If you expect it to decrease you will choose a “short position”. Then you decide on the contract size, in other words, how much you want to invest.
If the price moves in the direction you entered the contract for, you profit on the amount the price changed. For example: if you entered a long position on a CFD for gold and the price increased from 1250 to 1280 your profit is as follows: (1280-1250)*contract size. Or, as an example for a short position: let’s say you entered a contract when the price of oil was 53.20 and the price goes down to 52.00. In this case, your profit will be (53.20 – 52.00)*contract size.
These are two examples in which you make a profit trading CFDs. Please keep in mind, that you can lose if the market does not move in the direction you predicted.
Advantages of trading CFDs
We can point at two obvious advantages in trading CFDs.
First, CFDs are more affordable. The initial investment is significantly lower for the same potential profit or more. This also means that a trader can enter more trades.
Secondly, it is possible to profit from a falling market and not only on a rising market price. This further increases the possibilities for profit. A high volatility of the market can work to the advantage of a trader.
CFDs trading allows you to trade a variety of different asset classes, rather than having to specialize in one market.
The fact that CFDs are leveraged financial instruments can work to the advantage of the trader. Make sure to read our related e-books and use the education section on the Wilkins platform for a better understanding.
Risks involved in trading CFDs
To the same extent that the leveraged investment can work to your advantage in a case of profit, it can work to your disadvantage when it comes to a loss. The investor can quickly lose his/her full investment in case a position does not move in the direction covered in the contract. In situations where the broker has no protection against negative balance, the investor may end up losing more than their initial investment. In order to prevent this, brokers usually demand an initial margin, which is a specific amount that needs to remain as a buffer on the account.
Nevertheless, leveraged trading still bears a larger risk factor than investing without leverage. More information and ways to get understanding can be found in our educational section.
Beginning investors run the risk of getting carried away. It is easy to enter numerous trades and try out different instruments because the amounts invested are not very high and Contracts for Difference are usually short-term investments. Beginners are therefore advised to stick to a clear plan and inform themselves about risk management before investing heavily.
Hedging with CFDs
Apart from trading CFDs as a financial investment, you can also use CFDs to manage your investment risks. Investors with preexisting portfolios of stocks typically use CFDs to protect the value of the investment over a short-term period. By hedging the value of the portfolio with CFDs in the opposite direction, an investor not only gets to protect his investment but also gains the possibility of making a profit simultaneously.
While the mechanics of CFDs are pretty simple to understand, you have to bear in mind that CFDs trading is a high-risk activity. You should only participate with money you can afford to lose if you are interested in venturing into CFDs trading.