Introduction to Contracts of Difference (CFD): Basic Things You Need to Know

“Introduction to Contracts of Difference (CFD): Basic Things You Need to Know” by Julia Beyers

As a popular derivative in the trading ecosystem, a contract for difference (CFD) can be an extremely lucrative financial instrument. Because they allow you to speculate on various assets, including equities, commodities, and cryptocurrencies, CFDs can be a great way to add some versatility to your portfolio without ever owning any of those assets. 

This article will give you a full rundown of CFDs, what they are, and how they work. We will also cover their advantages and the different asset types they can encompass. Finally, we’ll discuss some of the inherent risks of CFD trading to help you stay on the safe side of your venture. 

What Is CFD Trading?

A contract for difference is an agreement between a broker and a trader that speculates on a given asset’s price difference. In a nutshell, the trader can either buy or sell several CFDs and profit from a price movement to the upside or downside. They are considered derivatives, as traders never purchase the asset itself. Instead: 

  • If a trader supposes the price will rise in the future, they open a long position (buy) and profit from the price increase at the end of the contract. 
  • If a trader supposes the price will fall in the future, they open a short position (sell) and profit from the price decrease at the end of the contract. 

Worth noting is that CFDs are usually traded on leverage, which means that traders can enter positions with small amounts of capital for greater profits. For example, if a trader uses an x5 leverage on his $100 position, he will be able to buy or sell $500 worth of CFDs. 

However, this means that you will need to have sufficient collateral to cover the expenses if the trade doesn’t go your way.

Reasons Why Traders Like CFDs

CFDs are extremely popular in the trading community for many reasons. So let’s look at some significant benefits that provide CFDs with an edge compared to trading traditional assets. 

  • Low investment threshold. Since CFDs are mainly traded with leverage, you can make significant profits with a modest starting capital. 
  • Ability to go long or short. You can speculate on both market directions through CFDs, up and down. It allows you to profit regardless of the current market environment and capitalise on every market movement. 
  • Not investing directly into underlying assets. When trading CFDs, you are never directly buying the asset; instead, you are just speculating on its price. It allows traders not to worry about storage and paperwork that usually comes with purchasing trading assets. 
  • Access a wide range of global markets. CFDs allow you to trade financial instruments otherwise unavailable in your region. 
  • Hedging capabilities. CFDs are commonly used to hedge against market fluctuations because of their low initial costs and high execution times. For example, if the market falls, you can lock the value of an asset from your portfolio by shorting it when the market goes down. 

All in all, CFDs are versatile and cost-effective financial instruments that allow you to access various assets from one broker.

What Assets Can You Trade With CFDs?

So, how far does the versatility of CFDs go? Let’s look at all the different types of assets you can trade through CFDs. 

  • Global market indices such as the SP 500, Nasdaq, UK 100, and many more;  
  • Forex markets and movement of global currencies such as the GBP/USD or JPY/EUR;  
  • Equities of public companies like Tesla, Microsoft, Apple, Meta, etc. 
  • Government bonds are securities sold by governments to cover one country’s debt. 
  • Change of government policies on interest rates. 
  • Option CFDs give you the right but not the obligation to fill out the contracts.
  • Illiquid assets such as commodities, including precious metals, energy (oil, gas), and foodstuffs (grain, meat). 
  • Digital currencies like Bitcoin, Ethereum, or Shiba Inu coin (without having to acquire advanced knowledge about cryptocurrencies or blockchain technology). 

Consequently, CFDs offer some of the best diversity of assets compared to other financial instruments. 

Risks of CFD Trading

You should note that CFDs come with their fair share of risks with all that in mind. First of all, CFDs are highly unregulated, which has resulted in them being banned in the US. It also means that traders are entirely dependent on the broker’s reputation, as they have no government body to turn to if things turn sour.  

Moreover, their highly speculative nature and leveraged positions can be a double-edged blade. While they can allow for considerable profits, their complexity can also result in severe losses for traders’ portfolios.

And finally, note that high volatility in certain asset types (stocks, cryptocurrencies) can lead to very high spreads between the buy and sell contract prices. 

Summing Up

As derivatives, CFDs carry a lot of benefits for traders, including increased exposure to global markets, low investment threshold, and high-profit opportunities. That said, they also come with a set of risks that you need to be aware of. Jumping into CFD trading without conducting due diligence and setting stop losses can be very costly and stop your trading adventure short.