WHAT ARE CFDS?
A CFD which stands for Contract For Difference is a financial product with is traded on the financial market. In essence, it is an agreement formed between an investor and a broker/dealer recording each side’s guess on the direction an asset price will go.
Investors find this method to be very beneficial due to the convenience a trader has on the price fluctuations of a financial asset. The most beneficial aspects are that no physical asset is being purchased, plus gains and losses are calculated based on the contract and the resulting asset price. With no physical claim to assets, investors can enter into contracts at lower costs.
You can find CFDs for virtually every asset groups. One of the most sought-after CFDs are ones dealing with commodities (i.e., gold, oil, sugar, coffee, wheat, silver, e.t.) Traders tend to find it very difficult trading in commodities due to the need for storage, and shipment of this favorite type of asset. This is where CFDs become an unbeatable choice for commodity trading.
CFD trading is not solely for commodities as most recent, other famed assets such as stocks, indices, or currencies have become a popular pick on online financial platforms.
HOW CFDS TRADING WORKS
The trick is to understand the basis for CFDs trading, once you have that covered the rest is pretty much straightforward. An investor first chooses an asset that he feels the value will either increase or decrease. When the trader feels the price will go up, he/she will select what is known as a “long position.” On the other hand, if the trader believes the asset will decrease in worth, they will choose a “short position.” The next step is deciding how much it is that you want to invest.
If the resulting amount moved in the direction you predicted or entered into the contract, your profit is based on the amount the price changed. For example: A long position on a CFD for silver with the price increasing from 1550 to 1580, the gain is as follows: (1580-1550)*contract size. For a short position: if a trader entered into a contract when the price of wheat was 43.20 and the price goes down to 32.00. Here your gain will be (43.20 – 32.00)*contract size.
In the above two cases, we showed examples of winning contracts. All traders should keep in mind that if the price of a given asset goes in the opposite direction as they predicted, then it will result in a loss on that particular contract. The math is the same as above.
ADVANTAGES OF TRADING CFDS
For advantages in trading CFDs, you need not look far.
The main advantage is that CFDs are more affordable. For the likelihood of the same profit amount, your initial investment is significantly lower than for other trading methods. Another plus for investors paying a low fee is the ability to enter more trades.
The second notable advantage is the ability to profit even when the market is falling. Just because the market is not doing well doesn’t mean that you won’t. With such a high volatility in the market, your chances for success increase.
When trading, you don’t have to stick to one specific part of the market, CFDs opens the doors to the entire market. You can enjoy all the asset classes and much more.
Being a leveraged financial instrument, CFDs add more conveniences to the trader.
RISKS INVOLVED IN TRADING CFDS
As previously mentioned, using a leveraged investment may work to your benefit when profiting. However, it may become a drawback when it comes to a trade that loses. An investor may hurriedly lose his/her entire investment if a trade goes the opposite direction, against the contract. There are times when a dealer can’t offer a protection plan against a negative balance, leaving the investor the possibility of losing more than their original investment. Brokers try to avoid this by requesting that the trader place a “margin” on the trade. The margin acts as a buffer in the account protecting some of the investment.
Regardless, on where the asset traded on or the direction a trade takes, leveraged trading still carries a higher risk factor than investing without a leverage applied.
Because CFDs don’t require a high investment amount, and due to their trades being short-termed, many new investors or beginners, end up being carried away by entering numerous trades. Amateur investors are cautioned and advised to start off by sticking to a precise plan and research how to practice risk management prior to over investing.
HEDGING WITH CFDS
CFDs can also be used as a means to supervise your investment risks. Traders who possess former portfolios of stocks are commonly known to use CFDs as a protection for the worth of their investments across a short-term duration. Investors increase the probability of profits and protect their current investments by hedging the price of the portfolio with CFDs.
Although the methods of how CFDs work seem simple to grasp, at the same time, investors need to be wary that CFDs trading is a high-risk undertaking. It goes without mentioning that a golden rule is that all traders should only partake in CFD trading with money that they can afford to lose.