What are CFDs?

CFD stands for Contract For Difference and it’s a derivative, i.e. a financial product that allows you to speculate on the price movement of an asset without actually owning it. When you believe that the value of e.g. a stock or currency will decrease, you can go short or sell, which means you open a CFD position that will generate profit if the market goes your way and the asset’s value does indeed drop. When you believe that the price of an asset will increase, you can go long or buy, which means you open a CFD position that will generate a profit if you’re correct.

CFD trading is risky and it’s important that you understand the risk, as well as any broker fees, before you dive in. It’s also important to note that it’s a leveraged trade which means you can trade on margin . You only need to invest a small capital (margin) which the broker will multiply (leverage) exposing you to a large position you wouldn’t otherwise be able to hold. Most brokers will enforce both a deposit margin, that is capital required to open the position, and a maintenance margin, that is a minimum account balance required to keep the position open.

So why should I consider CFDs if they’re so risky?

CFDs are advanced financial instruments so you should probably gain some trading experience in simpler markets before diving in. Once you’re ready to give them a go, start by researching the best CFD trading platforms and make sure you explore their charges. Most online platforms come with a warning about the risk of CFD trading, however its popularity is only increasing as investors want to profit from the covid-induced market volatility.

What makes CFDs attractive? First of all, it’s cheaper to trade CFDs than to trade the underlying asset , i.e. you may not be able to afford gold but you’re far more likely to be able to afford CFDs that speculate on the price movement of gold. Secondly, brokers provide very attractive leverage. Finally, if you choose well, you can profit both when markets go up and when they go down. This is something that seasoned investors take advantage of by using CFD trading as a form of hedging or minimising risk . Say, an investor owns stocks in company A and suspects that the stock price will drop. The investor can offset losses by going short, i.e. taking out a CFD that speculates on the stock’s value dropping.

Needless to say, everything comes at a price. The CFD market isn’t well regulated, you will pay the spread, i.e. the difference between the buy and sell price, and you will need to keep an eye on your maintenance margin. As with all leveraged trades, both the opportunity and the risk are multiplied.

Bitesize basics
  • CFD stands for Contract For Difference. This financial derivative allows you to trade on the price movement of various assets, without buying and selling the assets themselves.
  • CFD trading is leveraged, which means you can start with a small capital (margin) and the broker will then lend you money to give you access to a larger position.
  • The main advantage of CFDs is they allow you to profit both when markets go up and when they go down.
  • You need to research spreads, broker fees and maintenance margins well, because they may eat away any profit you make on small price changes.

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