“Contract for Difference” (CFD) is a term that may sound scary at first, but we’re here to break it all down for you.
The truth is that CFDs are often used by traders, and are much more common in the markets than you might think. And even if you are a beginner who imagines knowing absolutely nothing about them, you have very likely already encountered CFDs at some point.
What is a CFD?
Let’s start with understanding what CFDs actually are.
A contract, as you know, is simply an agreement between two parties — in this case, between a retail trader and someone authorised to provide financial services such as a broker or an investment bank. When it’s a contract for difference, what is being agreed upon is to exchange the difference in value of a particular asset.
A CFD instrument’s price is based on its underlying asset’s market value at any given time, and this frequently fluctuates. At the start of the contract, the underlying asset will be a certain price. When the trader decides to end the contract (i.e., close the trade), it will be another. The difference will then be calculated, generating either a profit or a loss for the trader, depending on how the price has moved (up or down) since the opening price of the contract.
The retail trader is not actually purchasing the underlying asset, but, rather, entering into a contract about the price. No asset ownership is taking place here. It is simply a financial service that the broker provides.
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Why CFDs have become so popular
While the traditional buying and selling of underlying assets is most common, there are many reasons why investors often choose to include CFD trading in their investment strategies.
CFD trading allows investors to leverage their capital and trade on the price movements of multiple assets such as stocks, commodities, indices and crypto without actually owning the underlying instrument or investing large sums of capital.
Leverage
Leverage trading makes it possible to gain exposure to an asset using capital which is a fraction of the position opened, since less margin (the amount of money needed to open a position) is required. Depending on the asset class, leverage may be applied in multiples, such as 2x, 5x, or higher in some instances. For example, you could open a $1,000 position on an asset with an initial margin of $200, if you were to apply 5x leverage on the trade.
It is important to note that use of leverage can increase risk, since profits and losses are always calculated according to the total size of your position, rather than according to the capital invested. In this example, the total size of the position is $1,000 and, as such, profit or loss will be calculated accordingly.
Using leverage requires a high level of involvement, as it is advisable to monitor your portfolio frequently. For more information on leverage, click here.
Short selling
“Short selling,” or “going short,” is a practice that enables traders who believe that an asset is overvalued, to open a position that will gain a profit in the event that the instrument’s price goes down. Short selling is also frequently used as a hedging tool. The ability to short assets provides traders with additional tools in their investment strategy arsenal.
Greater diversification
As explained above, with CFDs you have the ability to use leverage to lower the margin required to open the position. For example, say the price of one share of a stock is $1,000, and you have $1,000 total available capital to invest. Trading using a CFD allows you to invest $100 in that stock with 1:10 leverage, giving you an exposure of $1,000 to the asset without actually putting up $1,000 of capital. Since you only invested $100 in that position, this frees up the other $900 to invest in different assets, creating greater diversification in your portfolio. However, be sure to take the time to understand how CFDs work before applying leverage, since doing so can magnify losses.
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How much does it cost to trade CFDs?
Another component of the CFD contract is the broker’s fee for this service, which can vary. Investment fees are usually calculated by a percentage of the transaction or by a fixed fee per trade. CFDs, however, only charge the spread, which may be as small as a few cents per share.
It should be noted that because of the sheer number of users and volume of trades, online trading platforms such as eToro can more easily offer competitive spreads. This can make trading CFDs more worthwhile even for beginners looking to trade CFDs in small amounts to begin with. For more information on eToro’s spreads, click here.
Hungry for more?
If this article has whet your appetite to learn more about how to trade CFDs, head on over to the eToro Academy’s Trading 101 resource centre.
81% of retail investor accounts lose money when trading CFDs with this provider.