At first glance, CFDs, or Contracts For Difference, can seem fairly complicated.
However, in actuality, these derivatives are much simpler than you’d think. In trading these instruments, you enter a contract with the owner of the asset that allows you to profit from changes in value during the duration of your contract.
Here are six pointers to help you understand how CFDs work.
While traditional stock trading requires the stock purchase, with CFDs, you don’t own the asset. The CFD is borrowed using leverage by placing a deposit usually consisting of 5% or 10% of the market’s value.
Trading using leverage requires significantly less capital than outright purchasing stock, enabling you to spread your capital further. However, remember that price differences are calculated on the full size of the asset, not just the deposit you placed on it.
While that means that you can earn large profits from a relatively small investment, it also means you can experience huge losses compared to your initial outlay.
Master the Short Game
While traditional stock purchases result in profit when the market value increases, CFDs allow you to profit from falling market prices as well. This is known as going short.
If you believe a certain stock is headed for declining value, you sell it at the current price. Then when the price goes down, you buy it back at the lower rate and pocket the difference as profit when you close your position.
This ability to profit from drops in market value is a key benefit of Contracts For Difference trading.
Use Your Assets
When trading CFDs, there is a wide variety of options that brokers make available to you.
Most brokers offer assets for trading in all major global markets, allowing you to buy and sell shares, worldwide stock indices, major commodities such as gold and silver, foreign exchange pairs, and even cryptocurrencies. This large menu of options allows for the diversification of your portfolio.
However, experts suggest that you start small in the financial markets where you are most familiar and broaden your interests as you gain knowledge and confidence.
Notice the Similarities
There are many ways to trade without purchasing the actual asset; these are known as derivatives, and some examples are spread betting, futures, forwards, options, and swaps.
An advantage to CFDs is that they may seem more comfortable because of their similarities to traditional market trading because they mirror the asset being traded, even though the asset is not owned.
The success of your transaction will depend on the fluctuations of value, just like with traditional stock purchases, making the process more intuitive to people who are already familiar with financial market speculations.
Hedge Your Bets
Financial markets are inherently unpredictable, and there is always risk involved when investing. CFDs can be used as an effective hedging tool to help offset this risk by allowing investors to profit from falling markets.
For example, you may have a portfolio that includes a long position on shares in an airline. To hedge, you can open a short position to take advantage of price fluctuations.
Suppose a gasoline shortage causes your airline stock values to drop. In that case, you can buy low to close your contract and pocket the difference, helping to minimize the losses you may have suffered from your traditional stock holdings in the airline.
Watch the Margins
Leveraged trading is also known as trading on margin. The cost of opening and maintaining your contract (the initial deposit and any maintenance fees required) becomes known as your margin: the amount you have to recoup when you close your position.
Think of this as the cost of doing business, and keep the margin as a guideline for your trading decisions to ensure you come out with a profit.
The use of CFDs can be a valuable tool when implemented wisely as part of a comprehensive investment portfolio.