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CFDs are financial instruments that form a major component of a trader’s portfolio. They represent an efficient means of speculating on the financial markets. Yet, it can be difficult for traders to fully understand the upsides and drawbacks of trading CFDs, particularly at the start of their trading journey.
With this in mind, it is important to know what CFD trading is. To lend you a hand, this comprehensive guide will look into how CFD trading works while providing you with enough information you need to figure out whether it is a good financial instrument to invest in. So, keep on reading!
What Are CFDs?
CFDs – which is a term that stands for Contracts for difference – is a type of trading that ensures that investors can enter the financial markets. They are a form of derivative product in that they often obtain their value from the movement of underlying assets. With CFDs, traders do not necessarily need to own an underlying asset before they can trade price movements.
Traders who choose to trade CFDs can engage in contracts between brokers and themselves. There is an agreement between the trader and the broker to a contract that speculates on an asset’s price, based on market conditions.
How Does CFD Trading Work?
CFDs involve no buying or selling of an underlying asset – which could be in the form of a commodity, currency pair, or share. Rather, the trader can purchase or sell some units for specific financial instruments. This depends on the speculation of the price direction.
Profit and loss are essentially estimated by considering the difference in price between the entry and exit of a contract. This implies that if a gain is made, the seller who enters into this contract with a trader will pay the difference between the price at the start and the end of a contract. However, for a loss, the trader will pay the broker the difference.
The most important thing to consider in working out any profit or loss is to estimate the difference between the entry and exit prices, which is then multiplied by the number of CFD units.
CFD Margin And Leverage
When trading CFDs, it is important to consider margin and leverage. A major advantage of CFD trading is the fact that you can simply deposit a small fraction of the total trade value. With respect to traditional trading, leverage is higher with CFDs.
It is possible to use a smaller fraction of capital when opening a position. This allows for potentially larger returns. Besides this, it is worth noting that leverage trading is like a double-edged sword, capable of increasing losses the same way it can multiply profits.
Using CFDs For Hedging
If you wish to use CFDs for hedging, you can do so by opening a position that can turn out to be profitable when one of your positions starts to incur losses. An example of this involves taking a short position on a market that can monitor your asset’s price. If the asset experiences a drop in value, then there would be an offset by the profit from any CFD trade.
Take, for instance, you have some shares with ABC company. You predict that these shares may experience a fall in value in the long term. By going short on this company through a share CFD, an accurate prediction (that is, a fall in shares value) will ensure that the profit made from short CFD trades will offset the loss.
It is quite easy to trade CFDs with experienced brokers. All you need to do is open a trading account and select your instrument to start trading. To acquaint yourself with how the process works, you can always use a demo account to make sure that you are okay with your preferred instrument before entering live markets.