CFD is the contract between two parties that states that one party will pay the other the difference between the current value of an asset and its value at a future date. A contract for difference thus makes it possible to “bet” on the direction of an asset (rise or fall), without holding it, and to exchange with your broker the variance in price between the opening and closing of the contract.
When we trade CFD, we never own the asset, which makes this derivative such an effective way to profit from price fluctuations of different financial instruments. This is because it is quite similar to a futures contract based on a stock or index, and as a way to trade stocks and other financial instruments.
When trading CFD, it is necessary to know the financial derivative instrument to be able to trade with a higher probability of success.
A financial instrument is a contract by which we trade in a market for example bond, share, bill of exchange, futures or options contract, cheques, currency swap, drafts, or more. All the instruments serve different purposes hence the investors select instruments according to their preferences.
How does it work?
When trading CFD, it is necessary to know the financial instrument to be able to trade with a higher probability of success. Contracts for Difference have become extremely popular in many countries around the world, with the notable exception of the United States, where the Securities Exchange Commission (SEC) still does not accept them as investment instruments on financial markets.
It was first established in the 1990s and was primarily used by investment funds and institutional investors, but quickly became extremely popular with traders and individual investors in the late 1990s.
CFD, leverage and margin trading:
A CFD is a financial product that is often considered complex and risky because it is based on the principle of leverage and margin trading.
Contracts for Difference are traded based on a margin, and in the case of equity-based CFD, the margin is usually 10%. In addition, it is usually necessary to pay a commission of 0.1% of the face value of the contract to open and close the position, but this varies depending upon the broker.
What is the margin?
Margin trading permits you to borrow money from your broker to invest more. Thus, you benefit from a leverage effect allowing you to open a larger position than what your balance initially allows you.
Why leverage is risky?
Leverage also increases the movements of the underlying asset it relates to. This increases your return on investment. But it also means that when the market moves contrary to your desire, your losses are huge.
CFD trading rules:
· Protect your trading capital.
· Trading with the money which you can bear to lose.
· Do not burden yourself with over-leverage.
· You should always know your entry and exit level before starting your trade.
· Use a stop-loss always, it is a fixed amount of risk that a trader will accept with each trade.
· You should know that how many CFDs you want to trade.
Merits of contracts for difference:
Diversify an allocation with little money:
With Short Selling, you can profit from a fall in price. This technique is known under the name o Leverage helps you, without having to lock in an important money, to multiply your initial investment (as well as your gains or losses) and thereby trade a complete portfolio of stocks, indexes or commodities
You will benefit from a price decline. This strategy is known as defense or hedging. It is especially beneficial to hedge a stock portfolio against a decline in the economy.
Zero stock market tax:
CFD does not give any ownership rights and is not considered to be securities. You, therefore, do not pay capital gains tax on the sale of securities, because there is no physical purchase.
Gain and Loss – How does it work?
If your market situation is correct and the market is heading in the expected direction, your broker will pay you the difference between the opening and closing your trading position. It is then a profit, which would be added to your account balance.
With Contracts for Difference, it is just as easy to open a short position (short sale), whereby the trader receives a nominal amount of interest on his account. Another aspect that should be taken into consideration with CFD is that while the position is open, they are exposed to the market daily. This can cause the trader to suffer a heavy loss.
If you are not aware of the basic mechanism, you should not select CFD. You need to understand the fundamentals of trading in the markets.