CFD Trading Definition & Advantages
When two parties enter into a contract for differences (CFD), one agrees to pay the other the difference between the asset’s current market value and the value at the time of the contract.
With CFDs, traders and investors can speculate on price changes but are not required to actually own the underlying assets. The value of a CFD is determined only by the difference in prices at the time of entry and exit, regardless of the value of the underlying asset.
Here, we take a closer look at how CFDs work and why CFD trading can be advantageous.
A closer look at how CFDs work
An investor and a CFD broker make a deal to trade the fluctuation in value of a financial instrument (either a security or a derivative) between the opening and closing prices of the contract.
This trading method is only used by seasoned professionals because of its complexity. With CFDs, you are not guaranteed to receive any certain stock or product.
An investor in a contract for difference (CFD) does not take physical possession of the underlying asset but instead profits from fluctuations in the value of that asset. A trader, for instance, need not actually purchase or dispose of gold in order to engage in gold price speculation.
CFDs allow traders to speculate on the future price movement of an underlying asset or security. Traders have the option of betting on an increase or a decrease in value.
The investor who bought the CFD will put it up for sale if the price of the underlying asset rises. The difference between the buy and sell prices is calculated. The investor’s brokerage account is used to settle the difference, which represents the profit from the trades.
Conversely, a trader can initiate a sell position if he or she anticipates a fall in the asset’s value. A trader who wants to exit a position must first buy an opposite transaction. The remaining cash settlement deficit is paid out of that account.
The advantages of CFD trading
CFDs’ rise to prominence over the past few years is not hard to fathom given the many advantages they provide, such as exposure to a wide variety of markets, leverage, and lenient short selling options. Here are seven benefits of trading CFDs to consider if you still aren’t convinced.
Ability to profit from declining markets
The key distinction between CFDs and regular trading is that CFD holders never actually acquire ownership of the underlying market. There are a number of benefits to this, including the flexibility to both short and long distances.
Instead of buying a specified number of contracts when opening a short CFD position, the trader sells them. When you’re ready to get out of the transaction, you buy the same amount of CFDs that you sold.
This adds a whole new dimension to your trading, as it allows you to make money during market declines.
Let’s pretend you’ve done your homework and know that a certain stock is headed for trouble. You could short the company with a CFD instead of looking for a new opportunity, and make money if the share price drops. On the other hand, if the stock price goes up, you’ll end up losing money.
When shorting a CFD, you won’t need to borrow money like you would when investing. Going short is equivalent to going long, but in reverse. In addition to buying stocks, indices, commodities, and even bonds, you may also sell them.
You don’t need to use your own capital
Leverage is an additional perk of never having to actually own the assets you trade in. With leverage, you can open positions without putting up the full value; instead, you put up a deposit called a margin.
The reason this is possible is that you are not actually purchasing any market assets, but rather betting on their future price changes.
For example, if you want to trade R10 000 worth of GBP/USD, you may just need to put down R2,000. Therefore, you won’t have to risk your entire investment on a small number of positions.
Remember, though, that whether you make a profit or lose money will be calculated using the whole R10, 000. You would lose a sizeable portion of your margin, R500, if the GBP/USD exchange rate moved against you by just 5%.
Therefore, it is recommended to employ risk management strategies such as stop-loss orders, take-profit targets, and guaranteed stop-loss levels.
Similarities to traditional trading
CFDs aren’t your only option for speculating on the stock market without really buying anything. In addition to futures, options, and spread betting, there are many additional types of derivatives.
CFDs may seem a little more conventional than other derivatives if you’re used to more conventional trading and investing. Because in CFD trading, you are actually buying and selling contracts that are meant to function similarly to the assets they stand for.
The typical trading unit of a given market is one contract for difference (CFD). The size of your position is determined by the number of contracts you buy or sell.
You can buy a contract for difference (CFD) representing the value of 50 Apple shares if you want to trade the equivalent of that number of shares. By selling a contract for difference (CFD) on the South African Rand/United States dollar, one can short one currency pair.
Ability trade on a wide variety of asset types
You can trade virtually anything with a CFD broker because they often provide access to a large variety of asset types. Some markets which you can access through CFD trading include:
- stocks and shares, including major market players like Apple and Amazon
- Stock market benchmarks from around the globe, including the FTSE 100, DAX, and more
- Currency pairs that are major, minor, and exotic
- Gold, silver, and other strategic commodities
- Digital currency
- Also, all markets may be accessed from the same place, making it easy to transition from trading indexes to energy.
Ability to hedge
Keep in mind that short positions can be taken using CFDs. This strategy can help you protect your portfolio from the negative effects of market fluctuations while also allowing you to profit from lowering prices.
Let’s imagine you own 1,000 shares of Sasol and are concerned that a recent increase in oil prices would have a negative impact on the company’s short-term profitability. You might close your entire position by selling your stock.
One can short one thousand shares of Sasol using contracts for difference. Then, if your portfolio takes a hit, you can offset that loss with a gain from your CFD position. You may decide to liquidate your CFD position if and when airline stocks begin to rise again.
Reduced tax requirements
Trading without ever owning the underlying asset has significant tax benefits, such as avoiding stamp duty on market purchases and sales.
However, tax regulations might shift and rely on a person’s specific situation. Seek outside counsel if you feel the need.
Ability to practice trades
Opening a demo account is the best way to learn the ins and outs of CFD trading. You can practise trading with no risk using a demo account, which provides access to the price changes of thousands of financial marketplaces using virtual funds.
Tips for trading CFDs
Due to the many advantages they provide to investors, CFDs have been increasingly popular in recent years. Trading CFDs, however, is not without its risks. To aid you in your understanding of CFDs, we have provided some useful tips below.
- It is crucial that you fully grasp the nature and operation of CFDs before you begin trading.
- Learning more about yourself and your trading objectives is a crucial part of becoming a good trader.
- The aspects of trading can be laid out in detail with the use of a trading plan. It will aid in shaping behaviour and preventing emotional decision-making.
- Sticking to your CFD trading strategy is essential, since doing so will reduce the temptation to trade based on emotions such as fear and greed. Understanding when your trading plan is failing is equally crucial. To do this, you can back-test your trading technique and keep track of your wins and losses.
- Determine what kind of market analysis you will employ to determine when to enter and quit the market as you construct your CFD trading strategy. Technical analysis and fundamental analysis are the two main tools used by traders.
- External factors, such as macroeconomic statistics, company announcements, and breaking news, are the primary focus of fundamental analysis. The goal of technical analysis is to anticipate price movements by studying price charts from the past.
- The size of your position in the market is your entire exposure. Consider your financial resources and your tolerance for risk before committing to a new venture.
- You should specify in your trading plan the maximum amount of capital you are willing to lose on any given deal when trading CFDs.