What Are CFDs?
CFDs, or contracts for difference, allow you to exchange the difference in the value of a particular asset from the moment you open a contract to the moment you close it. Simply put, you get your profit from the difference in financial assets’ prices.
With these contracts, you can trade indices, stocks, futures, commodities, currencies – basically, anything. The price of the CFD is the price of the asset, and if the asset’s price is going up, so is the CFD’s price. The main feature of CFD trading is that you don’t actually own the asset: if you trade gold or oil, you don’t physically hold it.
How Do CFDs Work?
It’s important to keep in mind that when you trade CFDs, you do not trade actual assets. Rather, you speculate on the price of the asset in question.
With CFDs, you trade a particular number of units. You have two options.
- Buy, or “go long.” In this scenario, you expect the asset’s price to grow in the future. If you’re good with forecasting, you can get a serious profit even when the price changes are insignificant.
- Sell or “go short.” In this case, you sell the asset if you expect the price to go down. You can repurchase the same asset right after that at a lower price.
The main thing about CFDs is that they are leveraged products. Leverage is the ratio between the amount of money you deposit and the amount you can actually use in trading. Say, if the leverage is 1:100, it means that you can operate with the orders 100 times bigger than your deposit.
In other words, when it comes to CFD, you need to deposit a small percentage of the actual value of the asset – meaning, you don't have to deposit several thousands of dollars to access gold trading, the ounce of which is worth $1790. The initial deposit that you use for opening a CFD position is called margin.
For example, you want to buy a CFD for 10 ounces of gold. Considering that gold is currently trading at $1,790 per ounce, the overall amount of the CFD comes to $17,900. But if you’re using leverage of 1:100, you will only have to pay $179 from your pocket. And if the price of gold goes up to, say, $1,800 per ounce, you’ll get a profit of $100. Since your initial deposit was just $179, this is a great outcome.
It is an excellent advantage if you don’t have a significant initial sum to invest in trading. However, remember that although trading with leverage and margin increases your potential profit, it also exposes you to more risks and more significant losses.
Is Trading CFDs Safe?
First of all, engaging in any type of trading is quite risky. But generally, this trading strategy is recommended only to professional and experienced traders. Sure, trading with CFDs is highly profitable. But with high profits come high risks. Those risks mostly depend on the type of the asset you choose for your CFD, whether it’s volatile or not and how the global situation can reflect on its price. It’s also important to remember that although trading with leverage is a great way to make more money, you may also end up with a huge debt if your trade goes wrong.
So we can say that CFD trading is a very advanced type of trading and requires clear understanding of how the market works and ability to analyze and predict price fluctuations. Trading CFDs without a good strategy and risk management plan is not safe and can lead to unfortunate results.
Advantages of CFDs
When you trade ordinary assets with leverage, you have to provide at least 25% of the total value of the assets you want to own. But with CFD trading, this can be as low as 5%. What’s more, the minimum margin requirement can be even less than 1%, depending on the leverage. This means that you will have to spend less money, but receive much more profit if your trade turns out to be successful. Just keep in mind that higher leverage means higher losses if something goes wrong with your trades.
Global Market Access From One Platform
The world of trading is getting bigger and bigger every day, so CFDs are now available in over-the-counter markets all over the world. Finding a CFD broker is also not a problem since they offer their products in all major markets and you don’t have to look hard for a platform that offers CFD trading services.
No Shorting Rules or Borrowing Stock
If you prefer short selling, you might have encountered markets that prohibit it. Some markets also make traders borrow an asset first before allowing the trader to short it. But with CFDs you won’t encounter this problem because you don’t actually own the underlying asset.
Professional Execution With No Fees
CFD brokers rarely charge additional fees or commissions. They mostly make money from spreads that depend on the asset’s volatility. But as a rule, these brokers don’t have a habit of blindsiding traders with unexpected and unwarranted fees.
No Day Trading Requirements
CFD brokers don’t place limits on the amount of trades a trader can make within one day, nor do they have a minimum capital requirement for day trading. You can trade as much as you want every day, provided that your account has a required minimum deposit.
Variety of Trading Opportunities
There’s a wide variety of assets available for CFD trading, starting from stock and currencies and ending with oil and gold. This helps to diversify the traders’ portfolios and provides an alternative to traditional exchange markets.
Disadvantages of CFDs
Traders Pay the Spread
Unlike traditional markets that require traders to pay fees, commissions, regulations and other costs, CFD traders have to pay the spread when both entering and exiting positions. This doesn’t allow traders to profit from small moves and also decreases the amount of profit they can get from successful trades. Spreads also slightly increase the amount of loss they suffer from unsuccessful trades. Spread costs are the main source of income for these brokers, so you should remember about them while deciding on your trading strategy.
CFD trading is quite a risky business. As we already mentioned, there are leverage risks. While leverage does help you get more profit, it can also put you in a huge debt if your trade is unsuccessful. There’s also the risk of getting a margin call if you fail to maintain your margin account. If you’re not careful, your broker may close your positions, potentially leaving you with quite a lot of losses. And if the market is unstable, even risk management tools may fail to save you. So it’s very important to always keep a close eye on your CFD trades.
Example of a CFD Trade
Let’s say a X stock is currently trading $11 per share. You want to buy 1,000 CFDs because you expect the price to rise in the near future. To do this, you decide to use leverage. Your broker offers a 1:100 leverage with the initial margin requirement of 1%. This means that you only have to deposit $110 to your account (1,000 units x $11 x 1%).
Say, your prediction comes true and now each X share can be sold at $11.4. After you close your position, you get a profit of $400. Of course, you also get charged 0.1% when you open or close your positions, so you have to pay $11 and $11.4 (1,000 units x price x 0.1%) out of your profit. In the end, you’ve managed to turn your initial deposit of $110 to $377.6.
Can You Make Money With CFDs?
Yes, and quite a lot of it. But if you decide to trade CFDs, don’t forget about potential risks. It’s not a safe strategy for beginners, so you need to gain a lot of experience before committing to it.
The Bottom Line
Trading contracts for difference is an excellent way to enter the market without a significant initial investment. You need to remember about the traps that lie beneath the big leverage, but with a careful approach, CFD can become a substantial breakout for your finances. Check out the list of the available CFD assets in contract specifications.
2022-08-22 • Updated