CFD or Contract for Difference refers to the difference in the value of the asset between when a
trade is entered and exited. While trading CFDs, an individual never owns the underlying asset
which is being traded – but makes profits or losses in relation to the price movements of the
asset. CFD refers to a contract between the client and the broker.
How does CFD work?
Very simply put, all a trader has to do is predict the price movement of the asset or security
accurately. It has been opined that CFDs have emerged as an immensely versatile short term trading tool. They have ended up
gaining this kind of momentum quite simply because of the fact that they are an efficient tool to
not only maximize capital outlay but diversify existing investment portfolio as well.
In order to appreciate CFD as an immensely beneficial trading practice, one needs to understand
how it works at the first place. It should be noted that the logic working behind Contracts for
Difference is very similar to what’s behind the stocks. However, CFDs offer you more flexibility
than owning stocks in terms of applying leverage, setting stop losses and taking profit orders.
As far as trading Contracts for Difference is concerned, the “difference” can actually go in any
direction. While you are not purchasing the actual instrument or investing in it, you are actually
investing in the “price movement” of the same. If you think that the price of the instrument will
go up, you can buy it. If you think that’s it’s going to go down you can sell it.
Gold CFDs for example remain one of the most commonly traded today. A Gold CFD refers to
the theoritical order to buy or sell a certain amount of gold. The trader can make profits or losses
depending on his predictions in relation to price moves. A trader should venture into Gold CFD
– knowing full well that it represents a volatile market and 400-point moves are quite common
on a particular trading day.
Let’s take an example where gold CFD has an ask price of $1000. With 100 shares brought at
this particular price, the total amount comes to $100000. If you are working with a traditional
broker using a 50% margin, you would require to have at least $50,000 cash outlay. With a CFD
broker in place on the other hand, the trade would require only 5% outlay.
If you think that the price of gold will go up in future you can buy the commodity and sell it off
at a later date. This is called “going long”. In the falling market however, you should look to sell
a CFD position in the beginning and then buy it back later thereby closing out the position. This
is known as “going short”.
CFDs are basically leveraged products. The value of your CFD position will determine the amount of money you need to deposit.
CFDs are also backed by flexible contract sizes. The CFD contract sizes are less than that of the
contract sizes of the underlying instrument. It only means that the trader does have the freedom
to secure substantial exposure to the price movement of the instrument without really having to
make a huge deposit.
Winding up..you should not really forget the fact that leveraged products do come with their own
set of risks. High leverage only implies that the chances of making both profits and losses are
huge. You can even end up losing your initial deposit in certain cases!