What is a CFD?
A Contract for Difference (CFD) can be defined as an agreement that is made between a buyer and seller (often a buyer and a broker) without either of these parties having to own the actual asset being traded.
Each of these parties believes that their prediction in price for a specific asset/instrument will be proven right, thereby allowing them to profit from this transaction by settlement of the difference by the party whose prediction is wrong.
How it works
CFDs are actually derivatives, which means that they are based on the value of underlying assets such as futures, commodities, currencies and securities. In essence, the buyer and seller do not trade the actual asset therefore making the transaction more accessible to the public and less regulated. Instead, the buyer chooses an asset, speculates the direction that the asset’s price will go and in the event that the buyer is right, the broker is required (by the contract) to pay out the difference to the buyer.
If you enter a long position and the price of the asset appreciates, then the broker pays you the difference. For example if you buy gold at 1250 and the price reaches 1280, the broker is required to pay you the difference (1280-1250)*contract size. However, if you enter a long position and the price of the asset depreciates, then you forfeit your investment and you pay the broker the value of the each point that the market moved against you until your position is closed.
You can also make money in downward trending market where you take a short position if you speculate that the value of the asset will decrease. In this case if you sell oil at 53.20 and the price eventually reaches 52.00 then the broker is required to pay you the difference. Here it will be (53.20-52.00)*contract size. However, if you take a short position and the price of the asset increases, you will forfeit your investment and be required to pay the broker for each point that the market has moved against you until you close the trade.
Just as is the case with any investment that requires capital, it is important that you manage risk so as to come out of your trades in the positive rather than in the negative. It is important to delegate these kinds of transactions to competent individuals who understand the markets. Brokers will often have fund managers and account managers who control the transaction on your behalf. However, if you want to personally get involved in trading CFDs, you need to study all the relevant material to make sure you understand exactly what you are doing.
You can identify a credible broker with whom you will open a personal account and deposit your funds. You need to confirm that this broker is able to fulfil your trading requirements. From here you can identify which CFD you wish to transact in what amount of money you wish to risk. Tools such as stop losses and pending orders could help you ensure that you do not put your initial capital at unnecessary risk.
The main advantage of trading CFDs is that the cost is more affordable. This is because it is not the actual asset being traded therefore the margin requirements for these trades are much lower.
In addition to this, most platforms where CFDs are traded offer leverage which means that investors are able to take larger positions in the market using less capital and also exposes them to huge potential returns.
In the world of CFDs, there are less limitations when it comes to capital investment, the number of trades one can take and the type of positions one can take. For example when compared to stocks which are normally subjected to all these rules and regulation.
CFD markets offer a large variety of assets that the investor can trade in; from precious metals, to stocks, to indices, to currency pairs and other commodities. This empowers the investor such that they are able to access and make money from different assets (over 4,000) even when some are affected negatively due to one factor or the other.
While leverage is advantageous in the scenario where the investors’ positions are in profit, the inverse is true in the case of a losing trade. This means that an investor could quickly lose his/her full investment in case a position goes in the opposite direction. In situations where the broker has no protection against negative balance, the investor may end up losing more than their initial investment. However, this is no longer a common occurrence as most brokers are regulated and required to protect investors from such occurrences.
Keeping in mind that it is possible and sometimes advantageous to enter and exit positions severally, one must account for spreads which are charges that the broker imposes on the buyer for each of these transactions.