In this article, you will learn what CFDs are, why they are unique, how to trade them, the fees, and any risks involved. As a bonus, be sure to read our tips at the end to ensure you’re ready to trade safely and responsibly.
What is a CFD
A CFD is a specialized financial derivative product that allows an investor to trade on the price movement of an underlying financial asset without owning the asset.
In contractual terms, a CFD is an agreement between a buyer and a seller to either pay or receive the difference between the current value of an asset and its value at the end of the contract.
In other words, if the value of the asset goes up, the buyer pays; if the value of the asset goes down, the seller pays.
They were created in the early 1990s in the UK as a way to hedge against exposure to stocks on the London Stock Exchange. They became popular because they did not require large margins, and also because traders were able to avoid the stamp duty requirement because no physical shares were exchanged.
CFD Tradeable Instruments
Since no physical ownership of shares or currency takes place, the trader does not buy or sell the actual asset, but rather a specific number of units of the underlying financial instrument.
Traders can speculate on rising or falling prices on a variety of financial trading instruments, such as currencies, treasuries, commodities, indices, and shares.
Specific instruments include commodities like gold, silver, and oil; currency pairs such as GBP/USD, USD/CAD, USD/EUR; shares which are traded in major stock exchanges like the London Stock Exchange or the New York Stock Exchange (NYSE); and leading indices such as the Dow Jones, NASDAQ and Nikkei 225.
Costs of CFD Trading
CFD traders are subject to several fees, including a daily broker financing fee, the bid/offer spread, and any charges for holding CFD positions overnight.
Risks
There is a high element of risk involved with leveraged trading which can result in a high loss of trading capital.
Leveraged trading can magnify profits, but it can also magnify losses. For this reason, it is important to calculate both the positive and the negative potential of any trade prior to execution.
Unique features of CFDs
When compared to other investment instruments, CFDs resemble the futures and options market the most with a few differences, including:
- The CFD contract is normally on a one to one basis with the underlying instrument
- Trading is conducted with CFD brokers over-the-counter
- CFDs offer a small contract size as low as a single share
- There is a wide selection of underlying instruments
- New instruments, like cryptocurrency are easily created
Getting started with CFD Trading
When you start trading CFDs it’s important to find a licensed, regulated CFD broker that offers a safe and secure trading environment, and competitive spreads. One example of such a broker is Capex.com CFD online trading service but we are sure that there are others as well.
Tips for successful CFD trading
1. Use stop-loss orders
As with most trading, using stop-loss orders is considered good practice in order to limit downsides.
2. Diversify
Like any good investment strategy, the saying “don’t put all your eggs in one basket” also applies to CFDs.
3. Do your research
Understanding CFD trading basics is important, but real success means also understanding the specifics of the investment type. Most successful traders choose a small number of specializations they know well, and trade them consistently.
Another key to success is to differentiate the outlying “one-off” successes from what consistently works.
For example, some people made a lot of money on Bitcoin in 2017, but that does not mean it will happen again. Understanding blockchain, the technology that powers Bitcoin, may give insight to anyone choosing to invest today.
4. Balance leverage with risk tolerance
Leveraged trading may produce sky-high wins but has also created huge losses more often than not. Limit leverage to a level that is concurrent with your risk tolerance profile in order to minimize any potential losses.
5. Create a trading strategy and stick to it
Create a strategy before each trade and map out the high/low points.
This is important in order to avoid any emotional trading around chasing losses that may occur when adrenaline kicks in.
Conclusions
Available in a wide variety of underlying instruments, CFDs are a popular way to hedge against exposure to other investments.
No physical ownership of the instrument takes place – the trader buys a specific number of units instead of the underlying financial instrument, which can range from commodities to currency pairs to stocks.
Finding a safe CFD broker that is licensed by one of the reputable licensing entities like Cysec and FSCA is very important in order to minimize any security risks.
Profits and losses can be high due to the high element of risk involved with leveraged trading. As with most investments, the use of stop-loss orders, diversification and research is vital to understanding the market, and will ensure successful trading with minimal losses.
