Traders often use contracts for difference to expand their trading tools. They allow you to make a profit during uptrends and downtrends. Let’s talk about what CFDs are and what you need to know to use them correctly and make a profit.
What’s the point?
A CFD contract is an agreement between two parties (the seller and the buyer) to transfer the difference between the prices of an asset when the contract is opened and when it is closed.
Using it, you can fully trade simultaneously in various assets:
- shares;
- indices;
- currency;
- bonds
Features of these contracts
CFD is an abbreviation of Contract For Difference. It means speculating on the price movement of the chosen financial instrument. At the same time, the trader receives all the inherent benefits of trading shares without actually owning them.
Such a contract follows the change in the quotations of the asset and is concluded for a short period. Its purchase does not involve dividend payments. In addition, transactions are executed only between the broker and the trader.
Contracts were created to meet the demands of stock speculators with a small deposit since for operations with them only a fraction of the price of the underlying asset needs to be deposited. This type of trading is called margin trading, that is, with the use of leverage. Such contracts increase the number of participants, giving access to the market even to traders with little capital.
The working principle of CFD
This trading is the implementation of trading operations for the purchase and sale of stock and currency market assets.
When, for example, a trader predicts that a certain company’s stock will rise in price from $500 to $600, they can open a buy position at the current price and close it when it reaches the estimate. Trading contracts in such a situation has no significant differences and is no more complicated than trading real securities. You can make a profit by increasing quotations.
Let’s also consider the situation when a market participant assumes that the price of shares will fall. Then it is impossible to sell them according to the classic scheme, so it is worth using a contract for a decrease. For example, a trader assumes that the price of a company’s shares will decrease from $500 to $400. If the forecast is correct, you can make money on the downtrend. For this purpose, a trader may open a short position on the company’s asset for $500 and can potentially take profit at $400.
Advantages
The advantages of trading using CFD contracts are worth highlighting.
Ability to open deals in any direction
You can make money on the rise or fall of the price. Accordingly, a long or short position is opened. It is possible to make a profit even by reducing the cost.
No hidden fees
Usually, a broker provides all the conditions for trading. They are transparent and do not carry any tricks. You can find them on the website of the brokerage company.
Lack of actual ownership of assets
When, for example, a CFD contract for precious metal or oil has been purchased, they will not be transferred to a market participant and, accordingly, there will be no need to organize their storage.
Opening deals that exceed the scope of the trader’s capacity
This is made possible by the provision of credit leverage by the broker. This feature provides big gains and big losses if utilized incorrectly.
Expansion of the number of assets through a single account
Innovative platforms make it possible to manage active transactions using one trading terminal, which makes trading easier and faster. It is also a good opportunity for a comprehensive analysis of quotation dynamics.
Risks and disadvantages
A contract for difference is a complex instrument. Trading with its use is always associated with risk, so it is important to carefully understand what CFD is and what are the principles of its operation. Every decision should be well-thought-out. It is also important to realize for yourself whether you are ready to lose money.
High leverage
An increase in the potential profit due to the loan increases the probability of the deposit merging. To reduce this risk, the trader can use standard principles of capital management or create their own
High volatility
Such a situation carries increased risk, in particular when using large leverage. Fluctuations in assets are a natural phenomenon. The ATR indicator is used to determine volatility at different time intervals. Risk can also be minimized by using capital management principles or using hedging methods.
Speculative characteristics of the contract
The tool is used to speculate on assets without actually owning them. But it is worth considering that it is not always possible to make a profit in trading.
A trader can choose instruments for trading depending on the situation. In some cases, it is better to use contracts, in others – shares, currencies, etc.
Bottom line
This strategy is a great start for beginners since you can increase potential profits thanks to the credit funds provided by the broker. With their help, you can open more orders for a larger volume. This makes it possible to generate higher profits but, at the same time, one can lose more money than he can afford, which is usually the case.
Contracts are also suitable for hedging. In other words, a trader can profit from a short-lived downward momentum by selling or buying the equivalent value of securities.
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.
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