A contract for difference (also simply known as a CFD) is a type of trading instrument defined as a derivative. To put this another way, the price of a CFD is derived from the current trading value of an asset (such as a stock or an index). Many CFDs are traded on a margin basis. This signifies that only a small proportion of the total value of the asset is required to enter into a position. However, the mechanics behind these instruments can be confusing to those who are new to the sector. Let us examine the basic concepts behind CFD trading in a bit more detail.
Why CFD Trading?
Contracts for difference offer a number of interesting benefits. As mentioned previously, only a margin of the aggregate value of the product is required. Another point to make is that the investor never physically owns the position. This is in contrast to traditional share trading when a certificate is sent to the individual. Instead, he or she relies upon the differential. This is defined as the disparity between the price when one enters into the trade and when one leaves the trade.
The Concept of the Contract
Now that we have illustrated some basic concepts of a CFD trade, it is prudent to address the term “contract” in this context. A contract exists between the buyer (investor) and the seller (provider). This is normally associated with a certain time frame. For example, let us assume that a trader enacts a CFD trade utilising Apple shares as the underlying asset. He or she will then predict whether the price of these Apple shares will rise or fall within a given period of time. If their predictions are correct, they will profit. Should they have anticipated the movement incorrectly, they will lose from the trade.
The Benefits of CFD Trades
Besides the aforementioned margins, there are several other reasons why traders are interested in pursuing a CFD position. CFDs are normally associated with lower commission rates when compared to other assets. Also, profits can be made even when an index may be falling (recall that only the movement of the asset needs to be predicted correctly). CFDs are often used as hedges against other investments. Finally, investors can exploit the short-term price swings that will frequently occur on the open market.
Contracts for difference can represent short-term positions or long-term strategies. This will be influenced by the unique requirements of the trader. As only a small portion of the total price is required, CFDs are also attractive for those who are hoping to maximise their existing profit margins.
However, CFDs are not without their risks (particularly when referring to margin trades). Understanding the “nuts and bolts” behind these derivatives is important before taking up a live position. It is wise to peruse the CFD tutorial section offered by CMC Markets. This can help to address further questions as well as to highlight the attractiveness of such lucrative instruments.
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