There are a number of advantages to CFD trading. CFD stands for contract for difference. It is an investment vehicle that allows an investor to get profits from price fluctuations without actually owning the underlying asset. It focuses on the asset’s movement between the trade entry and trade exit. What’s important in this type of investment is the price change, not the value of the underlying asset.
With CFD trades, a contract is made between the broker and the client. These trades do not use the Forex, futures exchange, commodity exchange, or any stock. Over the past 10 years, CFDs have become very popular. The ability to trade anywhere online with a low cost makes CFD trading attractive for novice and expert traders alike.
Understanding How CFDs Work
With CFD’s, you can trade on the price movement of any financial market, including:
- Stocks
- Commodities
- Indices
- Currencies
So, if you think that the price of an underlying asset is going to increase, you can purchase a CFD and make a profit from that rise. This is referred to as going long.
Conversely, if you feel that the price of an underlying asset is going to go down, you can sell a CFD and make a profit from that fall. This is referred to as going short. Regardless of if you go long or go short, the profits you make are based on the difference between your entry price and your closing price. The more movement there is in the market in your anticipated direction, which is either up or down in value, the more profit you will make. It is also possible for the position to move against you. This would result in a loss of profit.
When you purchase a CFD, you are not required to pay the full value of the position. You only need to pay a fraction of it. This fraction that you will pay is called the margin. This style of online investing is referred to as trading on the margin.
The advantage of trading on the margin is that you have the ability to purchase more than you normally would if you were required to pay the full value of the position. This leverage effect is the primary reason why CFDs have become so popular. Investors love taking advantage of this leverage.
An Example of a CFD Trade
Let’s say that Apple is trading at $200. You feel that Apple is going to rise in value. You respond by purchasing 1,000 CFDs. In this example, Apple has a margin rate of 10 percent. This means that you only need to deposit 10 percent of the value of the trade as position margin.
One thousand CFDs at $200 equals $200,000, and 10 percent of $200,000 is $20,000. This means that in this scenario your position margin is $20,000. Let’s say that we made the right choice and now Apple finishes at $225. Now, your 1,000 CFDs multiplied by $225 equals $225,000. This means that you have made a profit of $25,000 by only investing $20,000.
It is important to remember in these scenarios that in the same way you can experience higher percentage gains as a stock goes up, you can also experience higher percentage losses if the stock goes contrary to your bet.
With this in mind, here are some of the reasons why trading CFDs may be right for your business:
- You can make a profit whether the market rises or whether the market falls.
- The leverage effect allows you to use your capital in an efficient way.
- Transaction costs are typically lower than other investment vehicles.
- You can trade 24 hours a day and benefit from fast execution.
Understanding the Risks of Trading CFDs
The first risk of trading CFDs is market risk. As we discussed, an investor will choose a long position or a short position based on what they believe the market will do. However, even the most educated investors can make a mistake. Changes in the market conditions, changes in government policy, or unexpected information that comes to light can quickly change the value of an underlying asset.
The strength of a CFD is leverage. But this leverage can also work against you. In some scenarios, as little as a few hundred dollars can give you influence over tens of thousands of dollars. As a result, a small change in the market can have a major impact on your returns.
A second risk is liquidity risk. Liquidity is a firm’s ability to be able to pay its debts without having catastrophic losses. A liquidity risk results from an investment lacking marketability, so it cannot be purchased or sold quick enough to minimize or prevent loss. When an investor, business, or financial institution is unable to meet short-term debt obligations, this is a liquidity risk.
A third risk is gapping. Gapping is where the price of a CFD falls before the trade can be executed at the previously agreed price. If you hold onto existing contracts, you will be forced to take less than optimal profits to cover the losses that were incurred by the CFD provider.
Day trading with CFDs is more risky when compared to other investment vehicles. That being said, it is possible, yet challenging, to create and implement a strategy that leads to consistent profitability. CFD trading should not be done on hunches.
Successful CFD traders use educational resources and follow a strategy. Trades cannot be made based on emotion. You need to master your thinking. If you are able to do that, then this trading vehicle may be right for you and your business. It is important to assess the risk associated with leveraged products. While the profit margin can be amazing, the resulting losses can also be more than one initially expected.
As always, we love to hear from our readers. What has been your experience working with CFDs? Have you found them to be a viable source of investment for your business? Do you have any tips or recommendations for people looking to use this investment vehicle? If so, let us know in the comments section below.
