One of the most talked about financial products in trading is the Contract for Difference (otherwise known as a CFD). Using these derivatives can be worthwhile, but there are risks involved when putting collateral into any endeavour, so let’s take a look at the fundamental principles of CFD trading.
What is a CFD and how does it function?
A CFD is essentially a contract that a trader enters into with a broker to define the specifics of a trading position. In these instances, you will use a small amount of your own collateral and borrow a set amount from the broker in order to take up higher-valued trades. The profit (or loss) will come from the difference between the current value of an asset and how much it is worth when the contract is ended. The asset price itself is irrelevant; only the movement in price between the opening and closing of the trade is considered.
Price movements are speculated upon and assets are not owned, so there is more room for multiple trades to be placed at any given time. CFDs are leveraged and this brings a whole host of advantages and disadvantages to trading, so it can be worthwhile to do some research before making any financial decisions.
Why use CFDs?
It can be less restrictive to trade using CFDs than say, investing, and it can be cheaper and offer greater potential (with a host of trading avenues to be taken advantage of). There are also more ways to trade, as users can speculate on both short and long positions.
The overall aim is to evaluate the leverage and margin of a position and decide if you will potentially profit if the trade goes your way. While beginners may find the process of entering contracts a little difficult at first, once traders have some experience with CFDs, the process will become more straightforward.
Why is leveraging a viable trading option?
The face of trading has changed significantly with the rise of the internet, digital trading and the range of technology out there supporting trading endeavours for people from all walks of life. In the last decade, leveraging has become a good way for those with little capital to get involved with a host of markets and potentially turn a profit. CFDs and spread betting are the most used leveraged products; you can learn more about trading CFDs here.
While it can seem worthwhile to use borrowed money alongside your own for bigger profits, traders should be aware of the disadvantages that come with leveraging – namely, that losses will be equated across the whole spread of the position, and not just the percentage you put in. This means that you can lose more than your initial investment. With the right trading platform, broker, tools and a good risk-management strategy at your disposal though, it can offer many more opportunities.
The risks
When embarking on your leverage trading journey, it’s important to understand there is risk involved so you should carry out steps to mitigate this. For example, ensure you’ve carried out in-depth research into the markets you’re looking to trade in. Make use of demo accounts to practice your trading strategies in this environment. You can also use stop losses to protect yourself from large losses.
The financial services industry is regulated by the FCA. To find out more about how it affects CFDs specifically, click here.
The pros and cons of CFD trading
Pros:
- Relatively low costs for entry-level and experienced traders alike
- Higher leverage
- Traders can use demo trading features to practice and get familiar with trading before putting any capital on the line
- There are no stamp duties to be paid
- Options to go short or long (speculate on rises and drops in value for gains)
Cons:
- Additional risks come with leveraging
- Markets can be volatile
- CFD trading can take some time if automated software isn’t utilised
Are leverage and CFD trading endeavours going to be profitable?
As with any form of trading, there are risks and rewards when using leveraging and CFDs to enter positions. With low margins for traders, easy access to markets across the world and little to no fees to consider, it can be a good place to start when you want to keep your outgoings low. Beginners may find entering CFDs a bit complicated at first and may be wary of the potential for significant losses, but there are ways to trade carefully.
Disclaimer
Spread bets and CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. The vast majority of retail client accounts lose money when spread betting and/or trading CFDs. You should consider whether you understand how spread bets and CFDs work and whether you can afford to take the high risk of losing your money.
Marketing for CFDs and spread betting is not intended for US citizens as prohibited under US regulation.
Tax treatment depends on your individual circumstances. Tax law can change or may differ in a jurisdiction other than the UK.