A contract for difference (CFD) is essentially a contract between you and a CFD provider or broker, which enables you to exchange the difference in price between opening and closing the contract. CFDs are a popular form of trading on the financial market, enabling you to access global markets, and speculate on the price movement of shares, indices and commodities in a single environment.
CFDs are high-risk financial instruments and are not recommended for those who are new to investing in general. This article is aimed at experienced investors who are looking to CFDs for a way of making leveraged trades in the financial markets.
How CFDs work – for beginners
To start trading CFDs, you’ll need to buy a number of CFD contracts (known as units), based on the speculated price movements on the assets in question. You do not own any of the underlying assets, but are essentially predicting on their position on the market.
Investors can buy or sell CFDs when the market is expected to rise or fall, capitalising on the price movements by trading these financial derivatives, reflective of the asset’s performance.
Gold is the most commonly traded CFD. This is because it offers some stability to traders during harsh and unstable economic times.
Advantages of CFD trading
There are both advantages and disadvantages to trading CFDs, and you’ll want to make sure you are fully informed and educated about the risks before investing.
- Open and close trades quickly
Your trade is always matched and filled quickly and efficiently, meaning you have constant control over your units.
- You can trade on both rising and falling markets
With the freedom to create your own trading strategy, and without ownership of the underlying asset, you can open either long or short positions, depending on the conditions of the market and your predictions.
- Regulated environment
When trading CFDs with an online trading platform such as Skilling, you’ll be rest assured knowing that all client deposits are segregated. There is also customer support, alongside extra information, readily available.
- Trade all different types of markets
CDFs allow traders to day trade a variety of different markets at any time, such as indices, forex, shares, commodities and more.
- Hedging
Trading CFDs offers you the chance to hedge against a negative event’s impact on your finances. If you own shares of a company and believe at some point their share prices will decrease, then you can use CFDs to quickly short them. You will either make a profit or just close the trade if the price increases, for example. The CFD in this case is a nimble and agile trade that you can make around a larger longer-term investment position.
- Use of leverage
Trading with leverage essentially multiplies the amount of money you have invested. For example, if you invest £1,000 and the leverage ratio is 1:30, you are able to buy or sell an asset (or assets) worth £30,000 (£1000 x 30). This means that you’ll have more exposure to the market, and this can increase profits drastically.
The use of leverage means that you won’t need as much money to actually begin day trading with CFDs. A £500 deposit could be used to trade a position worth over £10,000 depending on the financial instrument.
This can also be seen as a disadvantage, however, as it does work both ways. If you suffer a loss, your loss will also be amplified by the leveraged amount.
Disadvantages of CFD trading
As with any investment, there are some drawbacks of day trading CFDs. Here is an overview of the disadvantages and risks when it comes to trading using CFDs.
- Leverage
As stated previously, leverage can be a double-edged sword – and whilst it can offer incredible advantages, the disadvantages are just as prominent, should you suffer a loss. The best day trading books use real examples of leveraged trades to show how your return (or loss) on equity is increased if you make a leveraged trade.
- Interest
Some online trading platforms will charge interest on the total transaction, so watch out for this before investing.
- You will not own the assets
Any assets that you have invested in are not actually owned by you. Therefore, you cannot transfer your position to a different CFD provider or broker. If investing in shares, you will have no voting rights or say in the company, or receive dividend pay-outs, as there is no physical ownership.
- You may have to pay out more if you suffer a loss
If you suffer a loss and then want to sell your asset, you will be expected to pay the difference.
Conclusion of beginners guide to CFD trading
This is the close of our quick beginner’s guide to CFD trading. Please look for further resources to continue learning about this style of trading. Day trading is not easy, it’s difficult. Respect for this craft is needed to avoid disappointment. Consider reading some of the best day trading books to learn more about taking short term positions profitably and controlling your risk.
eToro’s social trading services, for instance, can be very tempting since you’ll only need to copy a trader’s position in order to invest. You need to keep in mind though that CFD eToro trading on stocks, commodities, forex and other assets offer not just possible profits but losses as well.
There are both advantages and disadvantages to trading CFDs, and you’ll want to make sure you are fully informed and educated about the risks before investing.
CFD trading is one way to trade in the market, but, like any investment, does not come without its risks. CFD trading is in fact a more risky form of investing compared to buying shares to picking the best companies to invest in via a traditional UK stockbroker. It is, however, an effective way to utilise a small amount of capital to make a short term bet on the direction of the markets. It tends to be more cost-efficient than traditional trading when you compare the fees relative to the size of the underlying exposure.
With the ability to trade on both rising and falling markets, and access to global markets, CFD trading offers traders greater control over how, where and when they open and close positions on the market.