What is CFD trading?
Learn what CFDs are and the risks involved before you begin trading.
If you’re an experienced trader or just curious about the industry, you’ve probably heard about CFDs. Risk is a key watchword associated with CFDs, a quick Google will give you lots of examples of traders making big losses with CFDs.
It’s true that CFDs are risky, complex products and are ideally suited to highly experienced traders. To learn about those risks head here, while this guide will take you through some of the reasons to trade CFDs and how to get into it.
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What is a CFD?
CFD stands for ‘contract for difference’. A CFD is an tradable instrument based on an underlying asset or financial instrument such as a share, commodity or currency pair. With a CFD, you decide whether you think the underlying asset will rise or fall in value between the time the contract is opened and when it is closed.
It’s important to understand clearly from the outset that at no point do you own the underlying asset itself, nor are you trading the underlying asset either. You own the CFD, or contract, which is provided to you by the CFD provider.
When you open a trade you can choose to either go long or go short. Going long means you expect the underlying asset (such as the share) to increase in value, and going short means you expect it to decrease. If you are correct in your assumption, you’ll be paid the difference in value.
However if you’re incorrect, you’ll owe the difference. You can also lose a lot more than your initial capital because of leverage. We’ll go into more detail about leverage later in this guide.
How are CFDs different to buying shares?
Investing in shares means you’re actually buying the underlying asset. That is, you are buying a share in a company. As a shareholder, you benefit from the capital growth of the shares’ value over time. When you sell your shares, you’re selling the actual asset and your holding in that company.
However, when buying a shares CFD you do not own the shares, you own the contract provided by the CFD provider. You’re simply speculating on whether you think the share will increase or decrease in value without ever owning or trading it. Think of it more like a bet on the share price.
So why trade CFDs?
- CFDs allow you to speculate on thousands of financial products and global markets which you may otherwise be unable to access.
- You can go long or short, hence you can benefit in both rising and falling markets.
- You can usually access free demo accounts, plus charts and trading tools through your broker.
- Unlike other types of derivatives, CFD contracts don’t have a fixed expiry date, meaning you can close out your position (in other words, end the contract to realise a profit or loss), when you decide.
What can you trade with CFDs?
Some of the most common markets you can access with CFDs are shares, indices, commodities like oil or gold, metals like copper and forex in the form of currency pairs.
However, you’re not limited to these. CFDs allow you speculate on many more markets like bitcoin and other cryptocurrencies, government bonds and even big events such as national elections. If you want to trade CFDs, you need to fully understand how the CFD itself works as well as the underlying asset. If you have no experience trading shares, for example, it may not be a good idea to buy a shares CFD.
What is margin and leverage?
Traders are only required to put in a small percentage of the trade’s value to open the CFD trade. This is known as the margin requirement, and can be as little as 5% of the full trade value or even less. You could think of this margin as the deposit.
For example, let’s pretend you want to trade Woolworths shares via CFDs, which are hypothetically valued at £10 per CFD. You decide to buy 100 of these CFDs, so the value of the trade is £10,000. With a margin of 5%, you are only required to pay £500 to open the trade.
Even though you only put forward 5% of the value of the trade, you’re entitled to benefit from 100% of the potential gains, as though you had put forward 100% to start with. This is what makes CFD trading attractive to so many people. Still, it’s important to remember that because you’re trading with leverage, the same applies if your trade was to lose. You’d be expected to pay the CFD provider for the entire loss, which could far exceed your initial 5% margin requirement. Plus, you could also be charged a commission on the trade by the CFD provider.
What is a stop-loss?
A stop-loss is a feature that helps to minimise a trader’s risk when trading CFDs. Traders can set the stop-loss for a particular price, so when the CFD falls below that price the trade is closed. This helps minimise your losses by closing the trade at a certain point before it continues to decrease in value.
Risks to be aware of with CFD trading
CFDs are extremely risky, complex products and are ideally only suited to very experienced financial traders. Here are some of the potential risks that you should know about before deciding if CFD trading is right for you.
- CFDs are complex.
CFDs are very intricate and confusing products. Even if you have a general understanding of what a CFD is, this doesn’t mean you’re ready to start trading CFDs.
- You can lose more than your initial capital.
If you gamble on the pokies, the most money you can lose is the amount you put into the pokie machine. This is not the case with CFDs. If you lose a CFD trade you can lose much more money than you started with, meaning you actually owe the CFD provider money, sometimes hundreds of thousands of dollars.
- You don’t own the underlying asset.
When trading CFDs all you own is the contract between you and the CFD provider. Therefore you can’t benefit from the capital growth of the underlying asset over the long term.
- CFDs depend on how the market performs.
Even though you don’t own the underlying asset, CFDs are still affected by market conditions. This can increase risks even more in a volatile market.
How to decide if CFD trading is right for you
Due to the complexity and high level of risk involved, CFDs will not be suitable for the vast majority of traders. CFD trading could be right for you if you:
- Are an experienced trader
- Have a strong understanding of not only CFDs but many financial products and markets
- Possess a high tolerance to risk, and are not at all risk-averse
- Can afford to lose quite a bit of money (it’s not guaranteed that you will, but you need to be comfortable you can afford to lose if you did)
- Have some level of legal expertise to understand the complexity of CFDs
- Are not interested in owning the underlying assets
- Understand the measures available to minimise your risk and are experienced using these tools, for example stop-loss orders
- Have conducted plenty of research – trading CFDs is not a decision that should be taken lightly
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