Contracts For Differences (CFDs) are contracts between an individual (investor) and a financial institution (an investment bank or a spread betting organisation). The investor analyzes the price movements and makes a trade based on the forecasted value of the particular assets. Such contracts are usually short term. When the contract ends, the parties will exchange the differences between the opening and closing trade prices. The contracts are settled in cash rather than physical goods, products or securities.
Investors can benefit from price movements without owning a single asset. In essence, contracts for differences are a trading strategy. They are a form of derivative trading. A derivative contract derives its value from the performance of the underlying assets.
How Exactly Does A CFD Work?
For a CFD to work, there needs to be a buyer and a seller. These two will come into a contract to exchange the differences in the value of a financial product. The investor doesn’t own the underlying asset but benefits from any revenue that comes from price changes of the underlying asset.
So for example instead of buying or selling a particular product or asset such as shares, an investor can simply predict the future value of the share-based on speculation. The forecast does not necessarily need to be an increase in value, investors can also benefit from correctly predicting values of assets going down.
Investing in a CFD is essentially a gamble. Studying charts and other forms of data cannot accurately predict how the values of shares will change. It is therefore not a trading strategy recommended for rookies or newbies. Statistics show that almost 76% of retail investors lose their money.
Buying And Selling CFDs
An investor will benefit based on the accuracy of the predictions made concerning the value of underlying assets. They can place their bets on either upward or downward movements of price values.
CFDs are based on two kinds of trades;
- Buying or selling – this creates an open position (the market entry point).
- Reverse trade – this closes the position (the market exit point).
Investors may buy CFDs if they anticipate a rise in the prices of underlying assets. If the predictions are correct, they will benefit from the rise in price value.
Investors may sell CFDs if they anticipate a fall in the prices of underlying assets. If the predictions are correct, they will benefit from the fall in price value.
If investors buy in their first trade, then the second trade will be reversed, in this case, a sale. If investors sell in their first trade, then the second trade will be the reverse of the same i.e. a purchase.
The determination of a profit or loss margin will be based on the difference between the opening trade and closing trade.
Advantages of Contracts For Differences
The majority of CFD brokers offer all their products and services in all the major markets of the world. This means that investors have access to CFDs around the clock and this gives investors around the world the freedom to trade from anywhere and at any time.
CFD brokers also offer the same types of orders that other traditional brokers do. Some of these orders include; limits and stops even contingent orders like “if done”. Often these services are offered at no extra cost.
Investors can trade in CFD while enjoying every benefit and taking all the risks involved in owning a security without owning it. Investors also don’t have to take any physical products. Contracts are settled in cash.
Disadvantages of Contracts For Differences
Investing in a CFD is very risky. Every trade needs to be closely monitored. It is easy to lose everything and have your position closed, leaving you with liability.
The CFD market is not closely regulated. It, therefore, takes a lot of investigating to determine which brokers are legitimate and credible. Before any account is opened make sure you know the reputation of the broker.
CFDs are an advanced strategy used in trading. It is hardly ever recommended for beginners. The benefits are good but the risk is very high. It also has a very low success rate, especially for retail investors.