What are CFDs and how can you use them to your advantage?
The Contract for Difference (CFD) is a derivative financial product traded out of the market, or over the counter (OTC). This type of contract allows you to take advantage of the price fluctuations of different investment instruments including stocks, commodities, indices, ETFs , without acquiring a specific asset.
Put simply, we can define CFDs as “bets” on the performance of a financial asset. In fact, these derivative instruments allow traders and investors to benefit from the rise (long position) or the fall (short position) of the price of underlying financial assets. Not surprisingly, they are often used to speculate in this type of markets.
Availability and regulation of Contracts for Difference
Originating in London in the 1990s, CFDs are currently available in the UK, Netherlands, Poland, Portugal, Germany, Switzerland, Italy, Singapore, South Africa, Australia, Sweden, France, Ireland, Japan and Spain. It is also expected to be introduced in the future for the Hong Kong market. In the USA , however, CFDs are not allowed due to some restrictions imposed by the US Securities and Exchange Commission (SEC) on over the counter (OTC) financial instruments .
HOW TO MAKE MONEY WITH CFDS: HOW THE CONTRACT FOR DIFFERENCE WORKS
CFD trading does not involve buying or selling (buying or selling) an underlying. It only provides that there is an agreement between two parties (buyer and seller) to exchange money based on the difference in price of the underlying asset between when the contract is open and closed. It should be remembered that each CFD replicates the performance of the underlying asset.
Let's take a concrete example.
If I believe that the price of a particular asset may rise, buying a long type contract will allow me to benefit in proportion to the rises. Conversely, if I think the price may decrease, I will take a bearish position by buying a short contract. This time I will have a gain in proportion to the decline in the stock.
As you could have guessed, the compensation and / or loss will be given by the difference between the purchase and sale price , for the size of your position, minus the spread, which is due to the broker.
CFD contracts do not have an expiration date . Consequently, positions can be closed at any time. To do this, simply execute an order opposite to that to open them. In other words, we will execute a sell order to close a long trade and a buy order for a short trade.
ROLLOVER FEE
Even if the CFDs, as anticipated, do not have an expiration date, the positions left open overnight are "reinvested". In fact, if you choose to leave a position open after the market closes, especially after 11pm CET, you will automatically undergo a rollover (renewal). As a result, any realized gains or losses will be calculated and credited / debited to your account, as well as any funding rates. Your position will be carried over to the following day.
However, there are also CFDs in the form of futures , which have an expiration after which the contract loses its validity and will be replaced by a new one automatically.
To avoid an overnight position , simply close that position by the expected rollover date and time.
FINANCIAL LEVERAGE
One of the aspects that characterizes trading with CFDs is the easy access to leverage. This double-edged sword allows you to access a greater amount of shares by taking advantage of a limited deposit.
In fact, trading with leverage or trading on margin allows you to open positions for a value greater than your trading capital. With AvaTrade, a broker that we reviewed in this article , for example, you can trade with leverage up to 30: 1. This means that with an investment of € 100 in a position with a leverage of 30: 1, you can open a position for a value of € 3000.
As you can guess, using leverage effectively in trading offers the potential to generate superior ROI. However, as anticipated, trading with leverage remains a double-edged sword as there is a greater risk to your capital in the event of unprofitable trades.
TRADING WITH CFDS: ADVANTAGES
As anticipated, the Contracts for Difference have opened the doors of the financial markets even to those who did not have large sums of capital to invest. In fact, with CFD trading, you never get hold of the asset.
On the other hand, with “traditional trading”, for example, those who want to buy just one Amazon share (Amazon.com, Inc.) must have around € 3,000. Or, those who choose to do day trading, and therefore do not intend to bind their money for a long period of time, for the purchase of a single asset a minimum deposit of € 10,000 of the same local currency is required in any case. It is then necessary to add expenses and commissions for opening and closing positions.
However, what accelerated their expansion in the 2000s, however, was the possibility of applying financial leverage to any underlying asset (possibility of leverage) and which we talked about a little while ago.
Other advantages of trading with Contracts for Difference include:
No Physical Ownership : Because you do not own the underlying, you do not receive any related rights or obligations, such as stamp duty or account management fees.
Simplicity and speed of execution : CFDs allow you to close positions even within a few minutes, making them suitable for short and very short time trading such as day trading and scalping.
Long or short availability and benefit from the rise or fall of a price .
Hedging potential through hedging .
Wide range of financial instruments.
DISADVANTAGES OF CFD TRADING
Traders appreciate CFDs for their vesatility and affordability. However, like any trading activity, Contracts for Difference also carry high potential risks .
In fact, on average over 80% of trading accounts lose money . The main reason for these losses with the use of CFDs is related to inexperience . In particular, the causes lie in the lack of mastery of financial leverage , already defined as a double-edged sword, and in the difficulty of managing one's emotions .
First, in fact, it is always important to combine theory with practice and test what you have learned on a demo account , the only risk-free account.
This, once again, makes us reflect on the importance of receiving adequate financial education and training as well as having the right notions of behavioral finance.
If you do not lack experience and behavioral finance and you have decided to trade with CFDs, if you wish, you can create your account with AvaTrade, broker among the pioneers of online trading .
Disclaimer: We may receive commissions if you open an account with this broker using one of our links.
Risk Warning: 71% of retail client accounts lose money when trading CFDs with this broker.
Risk Warning: The past results of other individuals and the strategies published within the Academy are proposed for educational purposes and therefore not always representative of the current reality of the markets or indicative of future earnings. CFDs are complex instruments and carry a high risk of losing money quickly due to leverage. 71% of retail client accounts lose money when trading CFDs with this broker. Consider if you understand how CFDs work and if you can handle the high risk of losing money.
DISCLAIMER: Alpha4All Ltd. educates the investor to manage their capital independently. It does not provide any type of advice or investment solicitation. Buying and selling financial instruments represents a high level of risk in which you can potentially lose all the capital invested. Only those who are aware of this risk should trade in the financial markets.
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