Contracts for Differences (CFDs) 101: A Quick Introduction

Contracts for Differences (CFDs) 101: A Quick Introduction

A Contract for Differences, or CFDs, is a very powerful derivative instrument to trade with. That’s especially true if you know how to properly use it to your advantage.

CFDs are highly leveraged instruments. They’re also cost-effective and tax-efficient. There are even funds that use CFDs as a significant part of their portfolio. This is a huge proof that CFDs can bring tons of benefits to your account.

If you’re planning to invest in CFDs, better check this article out and learn all the basics. Read on!

CFDs, or contract for differences, introduction

 

What are CFDs?

A contract for differences is basically an agreement between a trader and broker over the future price movement of an underlying asset.

If the asset seems like it’s going to rise, you can buy a CFD based on the day’s price. You’d have the view to settle for the difference in price at a later date.

In essence, this allows traders to speculate on price at the drop of the hat. It’s much faster than with other instruments. What’s better, it has a whole group of other additional benefits due to the structure of CFDs.

How does it exactly work?

Imagine the following situation. After performing research, you’re pretty sure that a company’s stock will rise in value. You’ve conducted fundamental analysis, as well as technical analysis. And all your data point to a short- to medium- term rise.

Read more: 3 Top Disadvantages of Technical Analysis

You then buy CFDs based of the current price of the asset. Afterwards, the company’s share price increased in value. You will then settle the position with CFD position with the broker. Then, you’ll bank the difference between the opening and closing prices. This will then deliver the profit portion of the trade.

CFDs don’t have any expiry date. You can hold the position for as long as you want. You’ll just wait until the outcome you desire presents itself. This is CFDs primary difference from futures and options trading.

 

CFDs mean contract for differences

Why start learning about CFDs now?

The simplest answer to this question is that the learning curve could be extremely steep. This is especially true if you start losing some money.

CFDs are very unpredictable by nature. It’s also so bulky. This means that many CFD trades don’t turn out great, unless the trader knows what he’s really doing. You can’t just shoot in the dark or play things by ear.

And even if you got the brains of Sherlock Holmes, predicting the market isn’t going to be easy. In some situations, a couple of points become the difference between gains and losses. And in that case, the central issue becomes the effective mitigation of losses while maximizing profits.

See also: Buying and Selling Shares: 10 Mistakes You Should Avoid

Should you trade CFDs?

CFDs are becoming more popular among traders around the world. Some figures have shown that CFDs account for nearly a third of all trading activity in Britain’s FTSE 100.

But before that, CFDs were considered to be only for investors with very high risk tolerance. That’s obviously because of the dangers it poses to traders and investors.

That’s not the case today.

More and more traders are betting on CFDs as their financial instrument. In fact, traders of all sizes and shapes can now trade CFDs. Thanks to its ability to deliver massive gains in a short period of time, the use of this instrument has become widespread.

To help you decide whether you too should also trade CFDs, the following are the other types of investors that use CFDs.

Retail Investors

Retail investors are those that pour their savings to investments for personal gains. They do this for their pensions or as a way to generate more return on their capital. Retail investors are normally the same types of people who buy managed investment funds. These are people who have some money to spare and want to use it as their investment capital.

What’s interesting is that as CFDs become more popular worldwide, the number of retail investors also shot up. There are now more and more CFD traders that belong to this group.

If you think you’re a retail investor, take it slow. Do not expose your capital right off the bat. Remember that it should be like a marathon—not a sprint. It’s always better to calibrate your investing speed to a number of years.

Try to stay in the game for the long haul.

Speculators and Day Traders

Speculators and day traders speculate on trading activities over the course of the day or shorter. There are high rewards across a short turnaround time. And that means greater return.

These types of investors tend to be keener than retail investors when it comes to the markets. They are also more professional traders, making a living via the market. They also tend to benefit more from CFDs over other financial instruments.

In addition, speculators gravitate towards low transaction costs and highly leveraged trades, as well as volatile markets. They try to spot short-term opportunities to profit from the markets. CFDs are suitable for the short-term endeavors.

Institutional Investors

Institutional Investors are organizations professionally engaged in financial trading activities. Normally, they are managing the assets of others to yield a return over time.

Institutional investors are more risk-averse than smaller trading operators. This is because they are accountable to their own investors. They cannot afford to fail. So they try to insulate themselves from risks.

In other words, they try to diversify their portfolios very much, throwing combinations of assets over periods of time.

Over time, CFDs have become a major part of institutional investors’ portfolio thanks to their inherent flexibility. CFDs can be useful for backing up winning and losing trades. It can also serve across a diverse range of markets.

Institutional investors use CFDs to recoup losses accumulated elsewhere and to bolter overall capital returns.

CFDs versus Futures

For new traders, the difference between CFDs and Futures are often not distinct. This leads to confusion for those who are still not sure where to invest.

CFDs and Futures, at first, will appear very much similar to the untrained eyes.

For one, they’re both derivatives. Then they provide the same leverage advantages, which are quite common to all kinds of derivatives.

To cite some differences, you could usually trade futures on exchanges. You can, however, trade CFDs directly with brokers. Overall, the main distinction is in the liquidity and financing of these two instruments.

As mentioned above, futures are also derivatives. Futures are a kind of contract that binds a trader into buying or selling underlying assets at a predetermined price at a specific date.

Futures work very similarly to CFDs. For one, you would bet on the future price of an asset based on its current price.

When the price rises, you can resell or execute the instrument on the expiry date for you to get maximum rewards.

You will find futures’ difference from CFDs in the manner in which futures have stricter rules. It has expiry dates, set quantities, and tighter rules of enforcements.

On the other hand, the futures market is extremely transparent. It tracks the underlying market more closely than CFD brokers. In addition, CFD brokers utilize the futures market as their basis for price determination.

Meanwhile, order filling for futures is a bit slower than when you trade CFDs.

CFDs versus Options

Aside from futures, Options are another kind of derivatives that are compared to CFDs. Just like futures, you can trade options on exchanges. Options’ distinct characteristic lies in the obligation, or lack thereof, that it brings to the trader.

While CFDs are straightforward agreements to settle on the price difference between the opening and closing, options are treated like assets in their own right.

Options give the holder the right to buy the underlying asset at the face price. Whereas futures require the trader to execute on the expiry date, options give the trader only the right to do so. In other words, you have the right to buy the underlying asset but you’re not obliged to do so if you don’t want to. This is where it got its name, “options.”

Markets to Trade with CFDs

You can trade CFDs on a wide range of assets, indexes, and markets thanks to their flexibility. This trait gives you the chance to diversify your portfolio even further. You can expose your portfolio to a broader range of assets.

The following are the markets in which you can trade CFDs.

CFDs on Stocks

You can trade CFDs in the stock market. In fact, this is where CFDs are most commonly traded.

You can choose from a diverse range of companies and sectors. This means that you can use CFDs to trade larger volumes of shares than what’s possible. This is due to the inherent leverage in CFD transactions.

For instance, with a 5 percent margin, traders can make transactions 20 times the size of their capital. This could enable much higher returns over shorter periods of time.

CFDs track shares price closely. Moreover, one contract usually equals one share. This means that using CFDs instead of a mere share grants you more leverage capacity.

Further, trading on CFDs saves you from some stamp duties, which are taxes payable on stock transactions.

Overall, trading CFDs on shares is cost-effective and tax-efficient.

CFDs on Indexes

This is another area where CFDs take center stage for traders. These indexes generally include global stock markets.

Some brokers offer markets on interest rates as the rely on the index when they write up CFDs. The reason behind this is that CFDs need to link to a price-tracking market. Different bases can make up markets.

For instance, the FTSE 100 does not link to an “FTSE 100 CFD” that is linked to any asset. Instead, the CFD links to an index of the FTSE. This would be impossible to do on a single transaction.

In effect, this solves a big problem for many investors. This problem is the difficulty of investing in a market as an overall reflection of economic performance. Therefore, traders can invest in indexes on the strength of economic and fiscal data.

CFDs on Commodities

You can also trade commodities across various commodities markets. You can trade oil, steel, wheat, soya, and other commodities with CFDs. These give you access to alternative (and usually highly volatile) markets, giving room for speculation and further investments.

When you combine CFDs and commodities, you can an even greater risk/rewards potential on these markets.

CFDs on Currency

The currency market is also a very popular market for CFDs. Currency fluctuations also serve as a basis for CFDs. This provides the trader a market in which he or she can speculate on economy and policy of the world’s richest countries.

Currency rate fluctuations can be highly volatile and they happen throughout the day and night. And even if it’s highly risky, it still provides a very much profitable venue for traders.

Once you throw CFDs in this mix, the profitability, along with volatility, will increase.  The good thing is that the costs are relatively low to deliver positions. And these positions are often several times larger than capital resources could allow. Such positions capitalize on the market movements in favor of your position.

Conclusion

In summary, CFDs are very powerful and flexible financial instruments that you can use to profit faster from the market. It comes with different features that make trading more exciting and competitive.

However, there are also many risks and downsides that you should be on the lookout for. Keep close tabs on the strategies that you can use to make the most out of CFDs.  Know your risk tolerance and the possible advantages and disadvantages of using CFDs.

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