Home Insights & Advice Understanding contracts for differences

Understanding contracts for differences

by John Saunders
6th May 21 2:39 pm

A Contract for Differences (CFD) can be used to gain exposure to an asset without actually owning that asset, and CFD:s are also widely used to speculate on indices and similar things that aren´t assets.

The performance of a CFD reflects the movement of the underlying, in relation to the opening price.

One of the many advantages of the CFD is that it makes it very easy to profit even from falling prices. Instead of going through the trouble (and risk) of short-selling an asset, you simply use the kind of CFD that pays you if the price of the underlying decreases.

Access to many markets, and at many times

Contracts for Differences is a great way to get access to a wide range of assets and instruments. Also, CFD trading is going on 24 hours a day, so there is always something available regardless of your schedule. If your broker has more limited trading hours, you could consider signing up with an additional broker to give yourself more flexibility.

Diversification

Since CFDs are available for such a wide range of assets and instruments, it is easy to achieve a high degree of diversification using CFDs, which is important from a risk-management perspective.

Since you do not need to own the underlying assets, you can gain exposure to expensive assets – and without putting all your eggs in one basket. Example: The price of one single a-share in Berkshire Hathaway Inc (NYSE: BRK.A ) currently exceeds 395,000 USD. This is far out of the budget for most hobby retail traders, but with a CFD you can still gain expsosure to this coveted share.

Low trading costs

The trading costs associated with CFD trading are typically very small. Always compare brokers before you open a CFD account, to make sure you´re not paying too much for your CFD trading.

With CFDs, there is never any transfer of asset ownership for shares, commodities or similar, so transaction costs can be kept at a minimum.

Some brokers actually charge zero fees when you enter and exit CFD trades. These brokers usually make their money from the spread instead.

No need to sell short

Another aspect that makes CFDs attractive to many traders is that it is so easy to use them to make a profit from falling asset prices. The traditional way of short-selling a share (or other asset) if you think the price will be going down is both cumbersome and risky, and typically comes with shorting costs. With a CFD, you cut out the need for any short-selling.

CFDs also make it easy to profit from falling non-assets, such as falling indexes (indices).

CFD and leverage / margin trading

Brokers that offer Contracts for Differences will typically also offer leverage or some other type of margin trading. This means that you can borrow money from the broker to make a trade, and you only have to come up with a part of the total sum on your own.

Example: You have $100 but want to risk $500. You borrow $400 from your broker to complete the trade.

Borrowing money from the broker is very popular among traders, since it means you can do big trades without having a big bankroll.

Naturally, risking money that you don´t own is perilous, since you can end up losing money you don´t have. You have to pay the broker back regardless of how the trade goes.

How to get started trading CFDs

  • Select and sign-up with an online broker that offers CFD trading.
  • Use a Demo Account (free play-money) to familiarize yourself with the trading platform to avoid costly beginner mistakes.
  • Make your first deposit into your trading account, and switch from Demo Account to Real-Money Account.
  • Decide category for your trading, such as forex, cryptocurrency, company shares, commodity, bond, interest rate, index, etcetera.
  • Within this category, decide on a CFD with the specific underlying instrument that you wish to get exposure to. Example: You think the S&P 500 index is going up, so you select an S&P 500 index CFD that pays if that index goes up.

Speculating on price increase = buying = going long

Speculating on price decrease = selling = going short

Bring up the trading ticket on your platform to see the current price. The first price is the bid (sell price) and the second price is the offer (buy price).

The price of the CFD is based on the price of the underlying instrument.

  • When you have selected exactly the CFD your wish to use, it is time to pick a trade size.
  • Adding a stop loss order and a limit order is not mandatory, but many traders use these tools as a part of their risk management and to avoid having to constantly check the market price of the underlying. (A limit order is essentially the same as a take-profit order.) Important: A stop-loss or limit order does not prevent you from closing the CFD manually. You can decide to take your profit earlier than the limit order, or close the CFD before the stop-loss kicks in.
  • Double-check all parameters and confirm the CFD trade.

 

The above information does not constitute any form of advice or recommendation by London Loves Business and is not intended to be relied upon by users in making (or refraining from making) any investment decisions. Appropriate independent advice should be obtained before making any such decision.

Leave a Comment

CLOSE AD

Sign up to our daily news alerts