CFDs, or Contracts for Difference, are a sort of financial derivative contract that facilitates price speculation. In addition to being easily accessible online, the cost of trading contracts for difference (CFDs) is inexpensive. However, CFDs may be a complex instrument, so it’s important to learn the basics before you start trading.
In this article, you will learn everything you need to know about Contracts for Difference, including what they are, how they function, the pros and cons of trading them, the steps involved in placing a trade, and much more.
What Is CFD Trading?
To put it simply, a Contract for Difference (CFD) is a legally binding agreement between two parties to trade the increase or decrease in the value of an asset between the opening and closing of the contract.
Looking into conventional investment is a fantastic first step toward learning how to trade CFDs.
Buying shares of a public firm is one option for those looking to diversify their portfolio. A person interested in investing in gold or oil could do so by purchasing a bar of gold or a barrel of oil, respectively. The next step is to sit tight and hope that the value of your shares, gold, or oil will rise, at which point you can sell it for a profit.
For the most part, CFD trading mirrors traditional trading in that the trader opens a position on an asset at a predetermined price and then waits for the asset’s price to move in either direction before closing the position for a gain or loss.
Trading Contracts for Difference is different from typical investing in that you do not really purchase the underlying asset. Instead, the price of the underlying asset is mirrored by the price of the CFD, and rather than actually purchasing the asset, you are only speculating on how its price might fluctuate in the future.
How Does CFD Trading Work?
It is better to use an example to provide a response to this question. Say you were interested in buying and selling gold through contracts for difference.
To speculate on an increase in the gold price using a CFD trading platform, you might initiate a buy (or long) trade. Gold’s price of $1,525 at the time of your CFD trade’s closure would represent a $25 gain over the opening price of $1,500.
If, however, you anticipated a decline in the price of gold, you might place a sell or short order in your CFD trading platform. Gold was trading at $1,500 when the CFD order was opened; if the trade was closed when the price dropped to $1,450, then you would have made a $50 profit.
What Are the Benefits of CFD Trading?
There are many CFD brokers who would be happy to present you with a laundry list of advantages, but it’s not always clear whether or not you can put faith in their claims. Continue reading for an objective summary of the overall advantages of CFD trading, and then we will discuss some of the risks that are associated with the investment.
- Leverage
The utilization of leverage is one of the most attractive features of CFD trading. With the help of CFD leverage, you can trade a higher volume of the market with a lower initial investment.
Your CFD leverage will be set by your broker and local regulator and will vary depending on the underlying instrument you are trading. Leverage as high as 1:500 may be available to experienced traders. Individual investors can get a leverage of 1:30 on some instruments.
- Trade Long and Short
One drawback of conventional investing is that profits are achieved only when market prices are rising. With contracts for difference, however, you can take advantage of both rising and declining markets by trading long and short.
It is the expectation of an increase in an asset’s value that motivates a trader to enter a long CFD position. As a result, they will initiate a ‘buy’ order at a lower price in the hopes of closing it (making a profit) at a higher price. The outcome, however, will be negative in the event that the market conditions weaken and the price falls.
The investor with a short CFD position anticipates that the value of the underlying asset will fall. Therefore, the trader will initiate a ‘sell’ position and then close it at a cheaper price, realizing a profit. Similar to long trade, a short trade will result in a loss if the price of the underlying asset goes in the opposite way from what was anticipated.
- Wide Range of Tradable Markets
CFDs are a type of derivative that may be developed to reflect nearly any market because they are derived from other assets. Moreover, several CFD brokers provide users with access to thousands of different financial markets through the use of just one CFD trading platform.
- Trading Hours
CFDs, as we have already discussed, are a reflection of the values of an underlying asset, and they are also a reflection of the trading hours of such assets. Every day of the week, regardless of the time, there is something accessible for trade.
- Short-Term Trading
Short-term trading is another strong suit of CFDs because they allow traders to capitalize on small price shifts in the stock, index, or commodities markets without having to put up a huge sum of money.
It is essential to select a CFD broker that provides quick execution speeds for their transactions if you intend to engage in short-term trading or even scalping. If you are considering either of these trading strategies, you should do so. It is crucial for a broker to be able to carry out trades in significantly less than one second, especially in markets that move very quickly.
- Expiration Dates
In addition to the previously mentioned advantages, CFD trades typically do not expire. While certain markets may have expiration dates incorporated into the trade, contracts for difference do not. Instead, you have the ability to close out your CFD positions whenever you see fit.
Trading for such extended periods of time removes the stress of thinking about having to close a position before you’re ready because of an impending deadline. However, there are situations in which a trade may be canceled on your behalf without your knowledge or consent. This may occur, for instance, if there are insufficient funds in your account at the time.
- Costs of Trading
Last but not least, the costs associated with trading CFDs are frequently less than those associated with other types of trading. CFDs have a cheaper cost of entry than other financial instruments because their margin requirements are lower.
What Are the Risks of Contracts for Difference?
CFD trading comes with its fair share of potential downsides, just like any other type of investing. Since CFDs are complicated products that come with a significant amount of risk attached to them, it is essential to conduct extensive research before deciding to use them.
Market risk is the most significant danger inherent in any kind of trading. You will profit (or incur losses) based on the market’s movement in relation to the direction in which you placed your trades.
As a result of the leverage associated with CFDs, however, losses can be multiplied relative to the initial investment; this fact emphasizes the need for utmost caution wherever leverage is employed.
Your account balance may go into the red, or negative zone if the market is particularly unstable. Keeping this in mind, selecting a CFD broker that provides insurance protection against a negative balance is of the utmost importance.
How to Trade CFDs
There are several steps to take, but we’ve simplified them for you in this short guide. Here are the steps for trading CFDs online.
- Create a Trading Account
It all starts with selecting a reliable CFD broker and opening an account with them. This might be a live account, in which you deposit real money and use it to trade on the financial markets; alternatively, this could be a demo account, in which you use simulated money to familiarize yourself with the trading platform and hone your trading skills;
- Download a CFD Trading Platform
When it comes to trading CFDs online, one of the initial things to think about is which platform offers the most advantageous trading conditions. When selecting a CFD broker, this is in fact another aspect that should be taken into consideration.
There is no requirement for you to use a specialized trading platform that was developed solely for the purpose of trading CFDs. If your broker provides contracts for difference (CFDs), then you will be able to trade those CFDs on the platform that they collaborate with.
- Choose Your Trading Strategy
Once you have an understanding of the basics of CFD trading, it’s time to choose your trading approach. It is essential to have a strategy in place before entering the market because there are so many potential transactions accessible across so many markets.
- Make Your First Trade!
Making your first trade, whether on a practice or real account, is the most thrilling part of learning to trade CFDs.