A CFD (Contract for diffence) is an acronym for contract for diffence and is currently the most widely used derivative instrument for online trading. It is a contract between two parties, the trader and a broker, which expresses the price difference of a market asset.
The difference is expressed between the purchase and closing price multiplied by the number of shares specified in the contract. It is a way of operating that is very similar to what happens in the purchase of shares. The prices quoted by the CFD broker are very similar to the market price and you can trade CFDs by receiving a commission charge.
This type of trading has become popular as an alternative tool that allows you to speculate on stock price movements but also on stock market indices.
Advantages of Contracts for Difference (CFDs)
There are many advantages that make them suitable for use by traders:
- trading on margin so that you can maximise your earnings
- there are no traditional stamp duties that you pay when you buy shares in a bank
- it is possible to earn money in any situation even when an action goes down not only when it goes up
- with just one account you can access many markets
- it is possible to make money management and set stops in order to control risks
These are leveraged financial instruments and can therefore entail risks of capital loss. Let us therefore try to list the main risks:
- both profits and losses can be amplified if no stop loss is set and open positions are negative.
- these instruments are not very suitable for those who love to invest in the long term
- by purchasing CFDs you do not become a shareholder of the company (this can also be an advantage at times)
Trading with CFDs
Let’s see how CFD trading works briefly by listing a few features that need to be taken into account.
Margin or margin trading
When trading CFDs for each transaction you do not need to invest the entire capital but only a percentage of the entire capital is sufficient, this is called initial margin. The leverage effect is achieved by using margin. In this way it is as if you have a larger amount of capital available due to the leverage multiplier effect. This way you can buy shares or speculate on forex in larger amounts.
This margin must be maintained on open positions to cover any losses. If an open position goes against your expectations, your remaining capital will be reduced. If this reaches such a level below the required margin there will be a Margin Call and additional capital will be required to keep the position open or you will be forced to close it.
Trading on rising or falling markets
From a technical point of view, trading with derivatives allows you to trade long or short positions. Long refers to the fact of buying an asset with the expectation that its value will increase just like buying a share. A short position opens, instead, when the trader believes that the price of the asset will fall and therefore you will have to sell it to make a profit. This type of situation is impossible if you invest in long term shares instead.
Using CFDs but also binary options you can go long or short very easily and make huge profits even when the value of an asset falls dramatically.
Trading fees and commissions
As you know, you pay very high stamp duties when you buy shares. For this reason it is always worthwhile to trade with CFD brokers, which are practically free of charge and offer much more convenient conditions.