What is a CFD?
A CFD is a ‘Contract for Difference’ and an agreement between two parties on the speculated rise or fall of an underlying or base asset. At the end of the agreement period the trader has been successful if they have correctly predicted the direction of change in the end of contract value; whether it has risen or fallen. This means that if it was correctly predicted that the share price in a particular company will have fallen after 4 hours, from 100p to whatever value, the trader would be paid for every percent drop in value below 100p.
How Does it Work?
There are two trading positions in a CFD contract; Long and Short. A trader will Go Short (sell) if they believe the share price (or any other type of asset) will fall in value over the agreed period. Even though CFDs are derivatives in that they achieve their value based on the movement of a base asset, the principle of value predictions is the same. The trader can be seen to have sold £1000 worth of shares today, and then bought them back for cheaper after they have dropped in value. This has been agreed upon between the trader and broker and cannot be backed out of. If the closing value had dropped to £700 during the contract period then the trader has earned £300 plus their deposit. The great thing about CFDs is that the trader does not actually buy anything in reality, but invests in the prediction of how their value will change. Because CFDs are derivatives they enjoy the benefits of leverage.
The Pros and Cons of Leverage
The fact that CFDs are leveraged products means that the full value of the trade is not required to open a position. Only a small deposit or ‘margin’, often 5%, is required to enable potentially large trades enabling investors to benefit from very small price movements. This is leverage in action. However, if the trade does not work in favour of the trader’s prediction, then they will lose to the value of the difference which could actually be more than what they had invested. For example, a trader goes short on CFDs to the value of £10,000 @ 100p each and the contract closes with the shares having risen to 110p. The prediction was wrong. The trader did not invest £10,000 but a 5% margin which equates to £500, but with a loss of 10p per share x 10,000 the trader has now lost £1000; £500 from the 10p per share rise and the lost £500 margin.
What is Margin Close Out?
One of the things that traders have to be weary of is margin close out, when a broker closes all of their open positions to prevent substantial losses. Margin close out happens when a trader’s deposits drop below a specific threshold and all positions are closed at the current rate which could cost the trader even more losses. The process of margin close out is usually an automated one so there may be no warnings. Traders should always make sure they are aware of the margin close out threshold for the broker they are using to avoid close out.
Hedge Your Portfolio with CFDs
Another advantage of CFDs is that they can be used as a hedging tool to offset losses in a portfolio. If a trader believes that a particular asset in their main portfolio may suffer a drop in value over a particular period of time, they can go short on CFDs of the same value for the same stock. If the asset suffers a loss then this loss will be offset by the gains achieved with the CFDs. Please note that using CFDs as a hedging tool should be carefully executed and not advisable for those who are still not too sure of what they are doing.
24 Hour Access to Thousands of Individual Markets
CFDs are available across thousands of individual markets and also offers traders exposure to all of the major global markets across Europe, US, UK and New Zealand. CFDs are traded online 24 hours a day offering investors an opportunity to work from home trading without incurring the over heads associated with starting an office for a new business venture.
Find CFD trading accounts with all of the major online brokerages such as CMC Markets and other well known companies.