What is a CFD? Truth and myths unvealed!

Asset classes

Miror
  • CFD stands for contract for difference.
  • CFDs are financial instruments or contracts, simple and inexpensive, that allow trading for all financial instruments such as stocks, indices, commodities, and currencies.
  • They work on a simple principle – require traders to anticipate the future value of underlying securities and take profit from price fluctuations without having to own those underlying securities.

Contracts for difference (CFDs) are financial instruments that allow investors and traders to trade financial assets without owning them. CFDs are actually contracts, simple and inexpensive, that allow trading for all financial instruments such as stocks, indices, commodities, and currencies. They work on a simple mechanism – demand traders to anticipate the future value of underlying securities and take profit from price fluctuations without having to own those underlying securities. In the simplest of words, trader profits or incur a loss on the basis of the price moving in his/her favorable or unfavorable direction. Let’s deep dive into CFD!

Once CFDs were only accessible to institutional investors. Now they have become extremely popular among small investors and traders as well. The reason for their huge popularity is remarkable flexibility. CFDs allow trading of security that no other financial product offers. Moreover, CFDs are issued by authorized financial institutions and brokers. They aren’t traded on any regularised market.

What is CFDs trading?

As we have already discussed that CFD trading is actually speculation on an asset’s price movement. A trader will simply buy the asset or take a long position if he/she believes the price of the underlying security will increase. On the flip side of the coin, a trader will simply sell the asset or take a short position if he/she believes the price of the underlying security will decrease. The difference between the opening and closing prices becomes the profit or loss.

How to trade CFDs? 

The CFD trading is interesting as you can take advantage of both types of price movements, upward and downward. 

Buying CFDs during an uptrend in the market

CFD trading strategy during an uptrend in the market involves buying the CFD and closing the position later by selling. If you believe that the price of the underlying security will increase, you can buy now at a lower price and sell at a higher price. The difference in opening and closing prices is your profit. However, if your prediction goes wrong, the price difference will be your loss.

Selling CFDs during a downtrend in the market 

CFD’s trading strategy during a downtrend in the market involves selling the CFDs and closing the position later by buying back. If you believe that the price of the underlying security will fall, you can sell now at a higher price and buy back at a lower price. The difference in opening and closing prices is your profit. However, if your prediction goes wrong, the price difference will be your loss.

What is leverage in CFDs trading? 

CFDs are very flexible financial products that also allow traders to execute trades greater than their investment. Most financial institutions and brokers allow traders to deposit a small portion of total trade value. This is called leverage. They allow full exposure against that deposit and thus magnify the overall gain of the favorable price movement of the underlying security. The level of leverage varies from institution to institution and requirements may also vary.

How much CFDs cost?

CFD trading costs are

  • Commission – Brokers generally charge no commission for commodities and forex pairs. However, they do charge commission for stock on both, opening and closing trades.
  • Financing costs – Financing costs are applicable in some particular situations. For example, if you take a long position, you have to bear financing costs. Brokers consider overnight positions as an investment. As brokers provide finance to investors to buy assets, they are entitled to charge interest. Investors have to bear interest costs for each day their position remains open.
  • The spread – The spread is the difference between the purchase price and the offer price. 

Advantages of CFDs

Contracts for difference offer a lot of advantages. These advantages are the reasons for the worldwide popularity CFDs have achieved recently. 

1. Exploit both trends in the market, uptrend, and downtrend

The biggest advantage of CFD trading is that they allow investors to take advantage of rising and falling markets. Investors have to register a prediction in the system. When their prediction proves true, they make a profit. Such trades are typically impossible in regular markets.

2. Leverage – Leverage or margin trading is another praiseworthy benefit of CFD trading. CFDs leverage allows investors to trade much more than they have resources to trade. It magnifies your profits if your predictions turn out to be true. 

3. Variety – Variety is another remarkable advantage of CFD trading. Traders have the opportunity to trade all types of assets with CFDs without having to own them. Thus, CFDs offer variety for trading and making profits. 

4. Fewer rules and regulations – Standard exchanges maintain different sets of rules and regulations. Conversely, CFD markets are very flexible in this regard. Capital and cash requirements in brokerage accounts are flexible and you can start trading with negligible cash. 

5. Less expensive – CFD trading has fewer costs associated with it as compared to other trading options. Brokers only make money by charging the spread.

Disadvantages of CFDs 

Although CFDs offer various advantages, there are certain advantages of CFDs as well.

1. Deadlines – Deadlines are the biggest drawback of CFD trading. The deadline date is associated with every position a trader takes. If the trader doesn’t close the position before the deadline, it automatically closes irrespective of being good or bad. The only way to postpone the deadline is to pay extra charges that are usually very high.

2. Can’t take long-term positions – If there is an associated deadline with every CFD trade, it is also obvious that traders can’t take long-term positions. If a trader wants to take a long position, he/she will have to postpone the deadline over and over again which proves very costly. 

3. Leverage or margin trading risks – Leverage or margin trading is beneficial but at the same time, it brings huge risk. If your prediction is right, your gains are high. However, if your speculation goes wrong, you have to suffer huge losses. Therefore, huge leverage risk is another major drawback of CFD trading. 

4. Other risks – As the CFD market doesn’t maintain rules and regulations, it can be very risky. You cannot wholeheartedly trust a broker as you trust brokerage in regular markets.

5. Not available in all countries – CFDs aren’t available for trading in all countries such as the United States. 

Final thoughts

So, we have discussed what are CFDs. CFD stands for contract for difference. CFDs are financial instruments or contracts, simple and inexpensive, that allow trading for all financial instruments such as stocks, indices, commodities, and currencies. They work on a simple principle – require traders to anticipate the future value of underlying securities and take profit from price fluctuations without having to own those underlying securities. In the simplest of words, trader profits or incur a loss on the basis of the price moving in his/her favorable or unfavorable direction. CFDs offer various advantages such as variety, leverage, and much more. However, traders must not forget to keep in mind the drawbacks and disadvantages of CFDs. 

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