Contracts for Difference
The following article is a guest post by Michael at tradingbeasts.com. The concept is new to me but we try to learn something new everyday. right?
Popularity of CFD raises – What is it and how can I trade it
Only a few financial derivatives have recently seen such a dynamic increase in popularity among retail investors as Contracts for Difference. CFDs are suitable for traders who do not possess a very large capital but still want to enter the market with fair and square conditions.
What can we trade with CFDs
Contracts for Difference can be used on all sorts of underlying assets. The most popular contracts are on stocks, indices, currency pairs or commodities. A CFD trader does not purchase a share ownership, but what he purchases is a contract for the specific stock, allowing him to buy or sell the specific asset for agreed price. Equally, he can buy a contract for a commodity. For example Gold, silver, cotton or copper.
How CFD trading works
CFDs instruments are traded at brokerage companies, with them the trader concludes a contract in which is stated that at the time of asset purchase, it is used the actual price of the asset. In the future, when the trader decides to terminate the deal, it will be again used the current price of the asset. If the difference between these two prices is positive, the broker pays this difference to the trader, and the trader earns money from the trade. Oppositely, if the difference is negative, this difference will pay the trader to the broker, making broker earn money. Everything works automatically and the contracts are conducted simply by hitting buy or sell buttons.
Leverage – let’s multiply our capital
With CFD we usually use leverage. This tool allows us, so to say to multiply our capital. This additional capital which is borrowed to us by the broker we do not own, but we can trade with it. And as you probably correctly assume, with a bigger capital we can earn more money (or we can lose more). That is also one of the reasons why people who can not afford to invest huge sums can earn a lot of cash. Usually, classic stock brokers require from you to deposit at least $1,000 (that’s the absolute minimum, most brokers require even more). But CFD providers allows you to trade with as low as 1 00$. And you still have the chance to earn as much as classic stock traders.
What is the main difference between CFD and classical stock trading
- Compared to a classic share purchase, CFD offers the possibility of a higher profit with a lower investment. On the other hand, just like the profits are multiplied, so are the losses (in case you use leverage). But you can still terminate the contracts at any time, allowing yourself to get out of the trade before it gets out of your hands. Such possibility is with conventional stocks much more complex because abolishing the trade takes a lot of time.
- CFD does not have to be used necessarily just on the incline of the asset. It is also used on regular bases to earn on the decline of the assets. Purchasing a CFD, assuming the asset price rises, is referred to as a “long position”. Conversely, buying a CFD, assuming a decline in the price of an asset is called a “short position”. Creating short positions gives you the opportunity to speculate on falling prices.
Well there ya have it. Something I never heard of before. Sounds a lot like options. I hope everyone strikes it rich!