CFD stands for Contract For Difference. CFD traders speculate on the difference between the buying and the selling price of an underlying asset. Although the underlying security must not be purchased by the trader, the value of the CFD is dependent from the gains or losses of the underlying asset. CFDs are available in all relevant markets, ie stocks, commodities, bonds and currencies.
Originally, Contracts for Difference were developed in the 1990s in Great Britain to avoid the stamp duty on stocks. Meanwhile, CFDs are recognized as innovative financial instruments throughout Europe and around to world and are also available for individuals through CFD and Forex brokers. Furthermore, CFDs are not listed but are traded in the OTC (Over The Counter) market. For that reason, CFD traders do not have to pay fees.
The speculative business with CFDs is particularly interesting for active day traders and intraday traders. Due to the high leverage, high profit margins on the invested capital can be achieved. Nevertheless, the traders must be willing to take risks and must have enough funds available, because the leverage effect can also mean huge losses. Therefore, CFD traders must know the market dynamics. A well balanced risk management must be used, as well as the knowledge of how to limit losses.
How does CFD Trading work?
In order to trade Contracts for Difference, the trader uses a special software from his CFD broker. This application handles all the relevant price information and calculates the leverage effect of the underlying product. All other necessary trading tools are available on the platform of the CFD broker. The software of the Forex and CFD Broker Plus500 for example includes functions to buy and sell, charting tools, access to real-time news and multiple analysis functions.
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In general, the trader can place orders for long or short positions. The main aim of CFD trading is to buy low and sell high. Above all, the right time of entry and exit is crucial. Therefore, a continuous supervising activity is essential during CFD trading.
With a Contract for Difference, the trader enters a deal with his broker that is not limited to a certain time frame. This means that no contract expiry date exists and that the maturity of the holding period of the positions is unlimited. The margin acts as a security for the broker. This may, depending on the CFD broker, be between one and twenty percent of the total value of the contract. Thus, the margin reflects only a small proportion of the actual value, resulting in the leverage. The CFD broker offer leverages between 5:1 and 100:1. With a leverage of 20:1, for example, the trader can speculate with an investment of $5000 with leveraged volume of $ 100,000. Hence, the higher the leverage, the greater are the chances to win, but the greater is the risk of a total loss.
Example of a CFD trade
A trader expects a rise in price of an underlying asset, and therefore opens a long position, ie he buys a position. The leverage is 10:1. So if he invests $1,000, he can trade a leveraged volume of $ 10,000 of the underlying asset. If the base value increases by five percent, this means an increase in value of the CFD position by $500. The trader closes the position in this moment, and he makes a gain of fifty percent of his invested capital, ie a $500 profit. If the price decreased on the other hand, the trader loses his money in the same way.
What are the advantages of trading CFDs?
Because of the leverage effect, a high volume can be traded with only a small investment. Even with a low capital investment, this effect causes a high earnings yield. Especially in volatile markets the prospects for high profits are good. Because the CFD traders can bet on rising and falling prices, there is also the opportunity to earn money in falling markets. On the other hand, volatile underlyings can cause traders to quickly lose their invested money. That’s why we recommend to only trade with money that isn’t really needed and to first gain valuable experiences by trading with a practice account.
A great broker for CFD trading is Plus500 – click here to open a demo account now!
(your capital may be at risk)