CFDs, or contracts for difference trading, are financial derivatives that offer the potential for large profits from small price changes. They are also known as synthetic trading and are a type of derivative that works differently from traditional trading.
Instead of buying or selling a real asset like a stock or ETF, traders with CFDs use them to speculate on movements in the price of an underlying commodity (the “reference”) or an index such as the S&P 500.
CFDs act like futures contracts on these underlying indices, but they can be traded just like any other financial instrument. The only catch is that CFDs involve much less flexibility than futures contracts because they are not as liquid nor can they be traded through standard brokerage accounts.
In this article, we will explore what CFDs are and how they work so you can make informed decisions about whether it’s right for your portfolio and trading strategy.
What is CFD Trading?
Let’s start by defining what a CFD is. A CFD, or contract for difference, is a financial instrument that allows investors to speculate on the price movement of an underlying asset.
The underlying asset could be an underlying stock, ETF, commodity, or even a foreign currency. The most common examples of CFDs are futures contracts based on stocks, commodities, indices, or foreign currencies.
While CFD trading differs from traditional stock trading in that it doesn’t involve actual ownership of the underlying asset, it’s still theoretically a long/short trade because it’s based on the idea that the price of the underlying asset will go up or down.
So while an investor only makes money if the price of the underlying asset goes up, they could lose money if the price goes down.
CFD Trading Strategies
Like stocks, commodities, or foreign currencies? Then you might be a good candidate for trading CFDs.
In this type of trading, users speculate on the price movements of an underlying asset based on the underlying asset’s price movements. Using this strategy, traders typically try to make profits on rising prices and limit their losses on falling prices.
Futures trading is a popular trading strategy for many investors because it offers low-cost exposure to major market indices, commodities, and foreign currencies. Traders use a contract, or “futures,” that’s based on the price movement of a specific asset.
Once the contract expires, the contract is settled and the asset’s price is determined. This can be an effective strategy for trading the price movements of indices, commodities, foreign currencies, and equity markets.
CFD Brokers
To trade a certain asset, like stocks, futures, or foreign currencies, a user needs to first open a brokerage account with a broker. Once the account is set up, investors can purchase and sell CFDs with the broker.
Several online brokerages offer CFD trading. With the right broker, investors can find a platform with the right tools and rates for their specific needs. Online brokers typically have superior customer service and tools like research, trading, and portfolio management solutions.
Choosing the right online brokerage can be key to success.
CFD Trading Limitations
CFD trading has many benefits, but it comes with some limitations as well. Like stocks, futures, and foreign currencies, CFDs are traded on a CFD broker’s trading platform. These brokerages typically have strict set limits on the assets they’ll trade.
Some brokerages also have leverage or borrow-based trading programs that allow users to buy very large positions with little money. Both of these factors can significantly increase risk.
So even though you can trade just about any underlying asset, it’s best to stick to low-risk investments and only trade a small portion of your portfolio.
Final Words: Should You Trade CFDs?
CFD trading is a relatively new and untested type of investing. While there are many benefits, it also comes with significant risks and limitations. Given the relatively new nature of these trading products and the significantly high amount of risk they involve, it’s best to stay away from them until they become more commonplace and regulated.
For now, the risks and regulatory issues involved with this type of trading make it best suited for experienced traders only. There are several risks involved with trading CFDs. The most significant risks are associated with exposure to significant price movements in the underlying asset and leverage.
If your portfolio is heavily invested in a specific asset and/or leveraged, you could lose a significant portion of your investment in a short period. CFD trading also comes with significant trading risks.
The platform used to trade CFDs is typically a trading platform that’s less liquid than traditional equity trading platforms. This means there are fewer buyers and sellers at any given time. This can lead to greater price volatility.