Defining Contracts for Difference
CFDs, or contracts for difference, are a type of derivative product. These contracts allow you to speculate on financial markets such as stocks, currency, indexes, and commodities without owning the underlying assets. Let’s discover them in more detail.
Since they are contracts, contracts for differences-just like any other contract, should have two parties who agree to certain conditions. The two parties included in this kind of contract are the individual investor and an investment bank or company. The agreement between these two is that they exchange the difference in the opening and closing prices of a specific financial item.
In fact, CFDs are one of the most popular and innovative investment tools, as those contracts allow you to trade on the price movement of any asset classes such as stocks, indices, commodities, forex, metals. However, you do not need to own the underlying financial instruments.
How to Trade CFDs?
In general, there are six steps that you should follow while trading CFDs. First, you need to understand how these contracts work. After you have got a good knowledge of them, you can open a trading account with a trusted broker, then fund it. Once that is done, you can draw your trading plan which will help you find trading opportunities. The following step is to search for a trading platform through which you can open, monitor, and close your positions. Here are more details about each step:
1. Understand How CFDs Work
We have clarified the working mechanism of CFDs in the introduction. Yet, let us simplify it and explain it in more detail.
A CFD, or a contract for difference, is a contract that allows you to trade assets without the hussle of owning them. With CFDs, you first open a position that is later to be closed through a reserve trade with the CFDs provider. If the opening position is a sell (short position) then the closing position is a buy (long position), and vice versa. If the opening position is a buy, then the closing position is a sell. The difference between the two trades is the net profit that the trader gets.
2. Open a Trading Account with a Trusted Broker
Now that you have got some knowledge of CFDs, it is time for you to start the real action. First, you need to find a trusted broker that is highly regulated and offers you some other advantages including high leverage and tight spreads. When you choose your broker, follow the steps required to open a trading account. Then, fund that account.
3. Start Working on Your Trading Plan
You will discover how valuable the time you spend working on your trading plan whenever you are under pressure. A trading plan acts as a reference for you as it includes your ideal kind of trade, desired profit, acceptable losses, and the ways to manage your risks.
4. Find an opportunity that is right for you
One of the greatest benefits of having a plan is that helps you find what works for you and what does not. In other words, it makes it easy to find an opportunity that is right for you. It is usually difficult to decide what your first trade should be as you have a lot of options to choose from like shares, cryptocurrencies and commodities. Therefore, you need to make use of all tools and resources made available to you to make an informed decision about your first trade or your later ones.
5. Search for an online trading platform
You can choose from a variety of platforms that brokers offer. These trading platforms range from the MT4, MT5 platforms, to web-based platforms that allow you to trade without the hassle of downloading any software.
6. Open, monitor, and close your first position
Here is when the real action starts. It is now time for your first real deal. You need to decide to go long or go short. Going long means to buy, while going short means to sell. If you think that the value of an asset will fall, you can go short. If you think it will go up, you can go long.
Advantages of Trading CFDs
Trading CFDs can hold some advantages over traditional investment. Here are some of those advantages:
1. Make profit even when the markets are falling
In traditional investment, you can only make profit if the price of a company share that you bought goes up. The situation is different with CFDs. Contract for Difference gives you the opportunity to make profit even if the price goes down because you can go short or sell the CFDs in case you believe the price will drop, as we mentioned earlier. It is possible to do that easily with CFDs since you do not possess the underlying asset.
2. Invest in a wide range of asset classes anytime and anywhere
You can trade CFDs of a wide range of asset classes such as shares, indices, forex, cryptocurrencies, commodities and metals via a simple login on a variety of devices after downloading a platform or using your web trader. You can access the device or trading platform anytime, anywhere, and you can even trade some markets outside of the trading hours. This is what we refer to as “after-hour-trading”.
3. Trade with leverage
A leverage is like a loan that you get from your broker to trade the markets with a smaller initial deposit. In other words, you pay part of the amount and borrow the rest from your forex broker. That is what makes trading CFDs more cost-effective than other investment options. With leverage, you can increase the monetary amount of the position to boost possible earning and multiply the rewards on your investment, but it is crucial to realize that losses are also multiplied, and you may lose more than your initial deposit. Nevertheless, this to be further detailed in the disadvantages section.
4. Get higher liquidity
CFD pricing is a direct reflection of what is happening in the underlying market. This means that CFDs give you access to the underlying market’s liquidity in addition to the liquidity provided by the CFDs broker
Disadvantages of Trading CFDs
CFDs pose some risks that you should be aware of when trading them. Some of these risks stem from the fact that you can:
1. Trade with leverage
It might sound strange that one of the benefits we mentioned before is the first disadvantage we list in this part. In fact, it is important to highlight the risks associated with trading with leverage and show that it can be a double-edged sword. Even minor price swings can wipe out a trader’s whole investment in some cases. This is why we cannot enhance enough the importance of having a solid trading risk management strategy.
2. Overtrade
Overtrading is the excessive buying and selling of an asset. This practice entails risks. Because CFDs are available to retail investors with little to no initial cost, some are tempted to over-trade. With overtrading, a trader’s remaining capital can be insufficient to cover the potential losses from all open positions. Therefore, it is critical that investors properly manage their open positions when trading CFDs.
3. Grow Costs with CFDs Trading
With CFDs trading, charges can accumulate over time if positions are left open for extended periods of time and are not handled correctly. In addition to the typical spread markup or commission charges, investors intending to open long-term trades should be aware of extra costs, such as swap, that are imposed for holding positions overnight. To achieve the greatest possible result, all potential charges should be taken into consideration before starting a position.
Now, you have learnt what CFDs are and got an idea about how they can be traded. Despite all the disadvantages these contracts might hold, they can bring good benefits if you know how to manage the risks involved, plan well, and keep learning and educating yourself in the world of trading.
