Contracts-for difference (CFDs) is a popular form of investing across a range of financial instruments that does not require buying or selling the underlying asset.
CFDs are offered by most brokers given their flexibility. They function as a derivative product that allow investors to speculate on everything from foreign exchange, commodities, and indices.
Getting Started with CFDs
The first step to trading CFDs is understanding how they function. CFDs are more flexible than simply buying stocks.
Rather, trading a CFD represents an exchange of the difference in the price of any asset relative to when the contract is open or when it is eventually closed.
This allows for speculation in either direction, as the profit or loss is dictated by whether you see the asset depreciating or appreciating in value.
Most investors are familiar with buying stocks – simply purchasing shares at one price with the hope of selling them later at a higher price.
CFDs are not much different and still afford investors the ability to trade in this traditional manner, albeit with forex, commodities, or even shares.
The primary difference with CFDs is the ability to short or open a CFD position with the hopes of seeing a decrease in price.
For example, suppose you are speculating on a decline in the price of gold. You can open a CFD for gold at one price and close it at a later period at a lower price for a profit.
By extension, if these shares rise, you would suffer a loss, for the difference of the price at closing the position relative to its opening price.
In either instance, both profits and losses will only be realized once a position is actually closed.
Understanding Leverage
Nearly all CFD trading is leveraged, which means traders are able to garner exposure of a position without effectively committing the entirety of the cost to do so.
This is common the trading of other assets such as forex, with leverage commonly seen at 10:1 50:1, or 100:1.
Using the above example of gold, an investor can trade a CFD of 100 shares of gold with the hopes of longing or buying a position at 10:1 leverage.
By using this leverage, you are only required to actually deposit 10% of the cost of these 100 shares upfront.
This form of investing is not without risk, which will be discussed below. However, leverage does enable the spreading of capital in ways that normally would not be feasible.
Forex trading for example is not plausible without the use of leverage for most investors given the high volumes needed to trade.
In the aforementioned example of gold shares, a trader’s profits or losses can be widely augmented and crucially, losses can exceed deposits.
Consequently, it is always important to pay attention to the leverage ratio that you are trading with to make sure this is within your respective means.
The Importance of Margin
Trading with leverage goes hand in hand with margin, which operates as the requisite funds required to open and maintain a position.
Your account at all times when trading with leverage should have extra margin on hand in case any position’s losses exceed your overall deposit.
This can result in a margin call, which sees the closure of all positions and the realization of all losses.
Overall, there are two types of margin that traders need to be aware of. Deposit margin is necessary to open a given position.
Conversely, maintenance margin reflects extra margin that can cover or buffer losses that your deposit would not otherwise reconcile.
Unlike other forms of trading, it is advised to keep a healthy pool of extra margin in your accounts to avoid any unforeseen losses or margin calls.
The best defense against this is to set trading stops.
These are levels that trigger and close a CFD position automatically to avoid a further move in either direction.
This is crucial in preventing your balance from going negative and owing more money than your initial deposit.
Conclusion
Overall, CFDs are a form of speculative trading that gives more flexibility to normal forms of investing. The trade-off is more risk however, and investors should be aware of these before actively trading.
CFDs cover an entire basket of assets and remain one of the most popular forms of investing on offer at any brokerage. See what CMS Prime has to offer by exploring its CFD offering today.
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