Contracts for difference, commonly abbreviated to CFDs, are financial derivatives that follow the price movement of an asset. They are a tradable contract between an investor and a broker, usually taking place on an online trading platform. CFDs allow the trader to gain exposure to the underlying market and its assets, speculating on the value of the assets involved, without the need to own the actual asset itself. The trade is based on the result of the movement in price from opening the contract to when it closes, making gains or incurring losses as a result of the difference in value of the underlying asset.
Trading using CFDs
Investors are able to trade using CFDs on all of the major financial instruments, including stocks and shares, commodity futures, currency pairs, global indices, and cryptocurrencies. For example, trading CFDs will enable you to speculate on the most common forex pairs from an online forex trading platform.
The aim of trading using CFDs is usually as a short-term investment, predicting the price movements in a particular market, and gaining a profit (or incurring a loss) depending on this movement and the size of the position taken. The contract has a buy and sell price, that follows the underlying asset, but is usually slightly higher or lower than the actual market value, respectively. The gap between these two prices is known as the spread.
The speculation of the assets’ value, alongside the fact that there is no ownership involved, also means traders can take a position on both a rising or falling market, with the price of the CFD mirroring that of the underlying asset.
For example, if a trader believes that the value of a share is going to rise, then they would open a buy position, also known as going long, with the aim to close the contract when there is a rise in price and profit from the difference in these two values.
When a trader predicts the price of the underlying asset, such as a different stock in the market or a commodity, they can open a sell position, also known as going short. The intention is to then close the contract when the stock has reached a lower price. The profit, or loss, is then dependant on the difference between the two prices of opening and closing the CFD.
In both cases, the gains or losses are dependant on whether or not the correct position is taken, and if the movement in value of the underlying asset follows what was predicted by the trader.
What is leverage?
One of the key points of CFD trading, is that it includes leverage. This enables traders to gain more exposure to the financial markets, but with less capital than what would be needed if they were to own the underlying asset, and exchange in a traditional trade. Therefore, when trading CFDs, it is seen as an effective use of capital, as investors can hold a much larger position on the markets, without having to deposit the full amount.
This type of trading is worked out using leverage ratios. For example, with a leverage of 1:10, you only need to deposit the value of £100 to gain the exposure worth that of £1,000. Leverage can multiply the profit gained from the CFD, but it can also multiple the losses. This is because the outcome of the trade is still based on the full value of the position and not the amount that was originally invested. It is worth noting that you should always research fully the process of leverage, as well as the leverage ratios involved when looking at CFD trading. With this option of leverage and the risks involved, CFD trading is mostly implemented by experienced traders.