What is a contract for difference (CFD)
- 1 What is a contract for difference (CFD)
- 1.1 What is contract for difference trading?
- 1.2 How does contract for difference trading work?
- 1.3 Advantages of trading a Contract for difference
- 1.4 Disadvantages of trading a Contract for difference
A contract for difference is known as the contract between an investor and an investment platform. When the contract ends, both parties involved exchange the variation between the entry and exit price of a particular financial instrument, which could be Forex, commodities, and shares.
What is contract for difference trading?
CFD trading refers to the buying and selling of contracts for differences through an online investment platform. By trading CFD you’re embarking on a contract to trade the difference in the price of an asset, from opening price to the closing price.
The profit or loss you generate relies on the accuracy of your predictions.
How does contract for difference trading work?
CFD trading operates by allowing traders to open a position on if the asset will increase or decrease in value. The main points to note of a long and short trade are leverage and margin.
What does it mean to go ‘long’ and ‘short’ in cfd trading?
Long and short trades in CFDs are terms used to describe the position a trader opens. In CFD trading, you’re given the ability to predict the market movements in both directions. If you open a long position, that means you believe that the price will increase, and going short implies that you believe the asset will reduce in value.
So, while you imitate a traditional trade that generates profits (or losses) when the value of the market increases, you can as well open a CFD trade that will generate income as the underlying market falls in price. This is also known as selling or going short, unlike buying or going long.
If you believe that the shares of Apple are going to reduce in value, for instance, you could sell a share CFD on the firm. You’ll still trade the price difference between your entry price and your exit price; you’ll be earning a profit if the shares are reduced in price and a loss if the price of the shares has increased. There is a risk involved when trading and losses could occur if the traders are not familiar with the broker or the instrument they have chosen to trade with.
What are margin and leverage?
Contracts for difference (CFDs) are known to be a leveraged product, which implies that you only need a small portion of the total value of the trade deposited into your trading account. Opening a position becomes relatively easy for traders who are low in cash, because only a little percentage of the entire value of the trade is required; this is known as margin trading. But bear in mind that with Margin trading your profits are maximized just as your losses are also maximized. This means that you could lose all your capital once a trade goes against you, but once the trading account has the negative balance protection, you won’t lose more than the value in your account.
Advantages of trading a Contract for difference
Several investors prefer to trade CFDs because of its numerous advantages that come with the contract. These advantages include:
- Various leverages
- The ability to go long or short on trades
- Range of trading opportunities
Brokers provide CFD traders with leverages up to 1:1000 compared to other normal financial instruments. For EU Citizens the leverage it is max 1:30. This can help improve the traders anticipated profits. Traders should also bear in mind that the higher the leverage the higher the chances of maximizing both profits and losses.
Go long and short
With CFDs, traders can either go long or short in a trade. Because the underlying asset is not owned, it only gives traders the ability to easily sell off the CFDs instruments without having to worry about extra fees or commissions.
Range of trading opportunities
CFDs are offered on a wide range of markets by several Brokers. By trading CFDs you can penetrate the commodity and indices market and get a kick out of the advantages and opportunities that come with it.
Disadvantages of trading a Contract for difference
Even though the advantages of CFDs are exciting, there are also some disadvantages that every trader should know of before trading any CFD asset.
CFDs save traders the stress of having to pay the additional costs that come with traditional trading, still, CFD traders are obliged to pay the costs of spreads. A CFD trader will have to pay the spread during an entry and exit of every trade. This means that generating little profits is near impossible.
CFD trading has its risk, these instruments are done quickly and they can be very risky. Traders are advised to have a good risk management strategy out in place, like setting limit orders, which can help in minimizing losses, but it still doesn’t remove the risks.