Your Guide to Understanding How CFDs Work
A CFD (contract for difference) is an agreement between a buyer and a seller that specifies that the buyer must reimburse the seller the variation between the present value of an asset and its value when the contract was made.
CFDs give investors and traders a chance to benefit from price shifts without owning the fundamental assets. The value of a CFD agreement doesn’t factor in the asset’s actual value; it only considers the price variation between the trade entry and exit.
This is achieved through a pact between the trader and broker and doesn’t utilize any commodity, forex, futures, or stock exchange.
Trading CFDs has a couple of substantial benefits that have increased this instrument’s popularity. That said, let’s look at how CFDs work and the risks associated with trading CFDs.
So How Do CFDs Work?
Now that you understand what CFDs are, let’s look at how they work. In order to understand how CFDs work, it’s crucial first to grasp the following concepts:
CFD trading is more akin to traditional trading as opposed to trading other derivatives such as options or spread bets. This is because CFDs are traded in standardized lots or contracts.
The size of an individual contract or lot depends on the fundamental asset being exchanged every so often, mimicking how that asset is exchanged on the market.
Duration of The Trade
More often than not, CFD exchanges have no fixed lapse date. As a result, you can close a position by simply placing a trade in the reverse direction to the one that opened it.
Spread and Commission
CFDs are quoted using the buying price and the selling price. What’s more, they allow you to profit from both increasing and dropping prices.
If you believe an asset’s price will increase, you buy or take a long position, and you’ll gain from every price increase. Conversely, if you believe an asset’s price will drop, you sell or take a short position, and you’ll profit from every price drop.
Of course, if markets don’t move as you expected, you’ll incur a loss. For instance, if you believe that Tesla’s share price will drop in value, you simply go short on Tesla share CFDs, and your returns will increase in line with any drop in price below your entry position. On the contrary, if Tesla’s share price increases, you will incur a loss for every price increase.
How much you gain or lose depends on your lot size and the size of the market price shift. The ability to take a long or short position alongside the fact that CFDs are leveraged goods makes CFDs one of the most versatile and popular ways of exchanging short-term movements.
What Are the Risks Allied to CFD Trading?
The appeal of CFD trading is that you only need to buy a small portion of the entire value of the asset you’re trading. Trading margins can be as small as 1%, so if you take a position with $10,000, it might only require a $100 deposit which is not a huge amount for investors.
If you have a profit, the cash you get will be based on the asset’s entire value. This means that your earnings can easily surpass the small margin deposit amount needed to hold the CFD. But, if you get it wrong, you may end up losing more than your primary investment.
Therein lies the risk of trading CFDs. You could also be subject to holding costs if your positions are still open when trading closes. You will also incur commission fees which will vary depending on the broker or trading platform you use.
CFD trading can be a beneficial approach if you’re looking to hedge investments in the fundamental assets and shares the CFDs represent, especially if the market is unstable. However, you can just trade CFDs completely on their own.
You don’t need to have other investments and only use CFDs as hedging investments. But make sure that you fully understand the risks involved before you embark on trading CFDs.
To sum it all up, CFDs allow you to profit from price movements without owning the fundamental asset. On the face, it sounds pretty straightforward, but CFDs have several risks linked to them. So you should be alert if you decide this is something you want to pursue.