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Contracts for Difference (CFDs): The Quick Guide to Derivatives Trading

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Traders and investors typically have a wide range of options available when dabbling in the financial markets. On the one hand, there are conventional investments in assets such as stocks, bonds, commodities, Forex, indices, ETFs and mutual funds and derivatives such as CFDs on the other hand. The aforementioned are usually the typical basket of investment opportunities. The degree to which traders allocate a percentage of their financial portfolio to each instrument depends upon the preferences of each trader.

However, the simplest way an investor can make money in conventional assets is to wait for the asset to appreciate – and this takes time. When companies use investment funds for growth purposes, they may also be able to pay dividends over time. Nonetheless, waiting for price gains and dividends is an agonizingly slow method of playing the markets. This piece provides insight on an interesting new way to participate on Wall Street.

Here’s how CFDs work in practice

There are other trading and investment options available on Wall Street in the form of derivatives trading and the most popular of the options is CFD trading. A CFD definition submits that it is an agreement between a buyer and a seller to buy/sell a contract of an underlying asset at a specific price, and a specific date in the future.’ The buyer may be purchasing on the assumption that the price of the underlying asset will rise at the contract expiry date.

Since no actual underlying assets are purchased, the CFD is simply a forecast on the price movement of the underlying asset. There is less regulation involved in CFD trading since no ownership takes place.By correctly speculating on the price movement of the underlying asset (bullish for an increase, and bearish for a decrease), the trader can pocket the difference at expiry time.

Example

For example, if the price of platinum is $1400 per ounce, and it rises to $1500 per ounce at expiry, the broker that facilitates the CFD must pay the difference of $100 to the trader. Since CFDs are traded in a specific size, the size of the CFD trade must be multiplied by the price differential (ie $100). CFD trading uses leverage and margin – these are essential to taking out much bigger positions in the actual contract.

Unlike traditional trading and investing, there is significantly greater leverage with CFDs. This means that you can open a much larger trade size. Leveraging, however, cuts both ways: if the trader forecasts correctly, you’ll book significant profits. However, if the price moves against you, the degree of leverage you have used in the trade will have a multiplier effect on the trade.

CFD trades are useful as a hedge against traditional investments in stocks, commodities, indices and currency pairs. In other words, your typical investments require an appreciation of asset categories, but CFDs can work in the opposite direction, price decreases. This is similar to a futures contract.

Traders can adopt short positions or long positions on CFD trades – it’s entirely at the discretion of the individual in question. Another benefit of CFD trading over conventional investments is that traders have complete control over their contracts. There is no need for fund managers or investment gurus – only an understanding of basic macroeconomic variables and the underlying financial asset is needed. To protect against market volatility, traders have multiple tools available including stop losses, rollovers, and other resources.

What are the pros and cons of CFD trading?

One of the major pros of CFD trading is that traders do not need to have the money to purchase the underlying stock up front before they can join the market. Consider the price of Google is well over $1,000 per share, but with CFD trading you can take out a large position on Google by using less margin and high leverage. The profits that stand to be gained from buying GOOG for example with just $1,000 cash in hand would require significant appreciation without leverage. However, with a CFD trade, a trader can leverage that $1000, 10 times, 20 times, 50 times or 100 times+.

Given that there are less regulatory constraints with CFD trading compared to conventional stocks trading, there is more leeway to manage your financial affairs as you see fit. In addition, the timeline for generating profits is significantly short with CFD trades.

The downside to CFD trading is evident in the losses that can accrue with trades that don’t go your way. Leverage once again plays a part in ramping up losses, and traders can lose their entire investment. If the broker does not offer negative balance protection, the investor may be on the hook for the full amount of the losing trade.

 

Views expressed are those of the writers only. Past performance is no guarantee of future results. Trading comes with severe risk. The opinions expressed in this Site do not constitute investment advice and independent financial advice should be sought where appropriate. This website is free for you to use but we may receive commission from the companies we feature on this site.
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Victor Alagbe

Victor Alagbe is a seasoned business and finance writer with a specialty in writing about how to invest for the long-term in healthcare, pharmacology, energy and tech stocks. His long-term focus is on stocks that provide a nice mix of growth and income. For the short term, he passionately writes about trading stock options for the excitement and leverage that stock options offer.

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