What are CFDs?
CFD stands for contract for difference. A CFD is a financial instrument that allows you to trade without actually owning the underlying asset. It is an agreement between two parties, known as “the maker” and “the taker.” The underlying instrument’s price needs to move enough for this arrangement to be profitable. If there were no movement, it would be considered a loss for both sides of the transaction.
How they work: Say you buy 100 shares of Google at $400 per share through your broker. By holding onto those 100 shares over time, Google’s stock price rises or falls with the company’s fortunes. You make or lose money on that investment based on how much the stock price changes.
Now, let’s say you want to profit from a Google price increase but don’t want to own the stock outright. You could enter into a CFD with your broker in which you agree to pay the current ask price for the CFD and receive the same payout as if you had bought the stock outright. You make money on both your investment and the CFD if the stock price increase; if it falls, you lose money on both.
The critical difference between holding shares of Google and entering into a CFD is that with a CFD, you never actually take delivery of the underlying asset. You’re simply speculating on whether its price will go up or down.
Advantages of CFDs include:
- flexibility – CFDs can be traded on margin, allowing investors to trade more prominent positions than they could if they were using traditional investments. This can result in greater profits or losses, depending on the investment’s direction.
- CFDs offer investors exposure to a broader range of assets than they could purchase outright. For example, you can trade CFDs on stocks, indices, currencies, and commodities.
- CFDs allow investors to trade on margin, which means they can use their investment as collateral for a loan from the broker. It will enable them to magnify their profits (or losses).
- CFDs are a tax-efficient way to invest in certain assets. For example, gains from stock CFDs are generally treated as capital gains, whereas you can offset losses against other capital gains or income.
- Because you never actually own the underlying asset, you don’t have to worry about dealing with things like dividends, voting rights, or stock splits.
- You can use CFDs to hedge an existing portfolio of investments. For example, you could use a CFD to protect yourself against a fall in the price of a particular stock.
- complex trading – CFDs are complex investments and can be challenging to understand. This can make it difficult to trade them effectively and lead to losses if trades are not placed correctly.
- CFDs are high-risk investments and are not suitable for everyone. You can quickly lose all of your investment if the market moves against you.
- CFDs are not regulated in the same way as stocks and other traditional investment products. It means there is no guarantee that the broker you deal with will be reputable or that your money will be safe.
- CFDs can be expensive to trade. The costs of trading CFDs can add up quickly, especially if you’re trading on margin.
- CFDs can be challenging to understand and trade. They are not suitable for novice investors.
- CFDs are a “short-term” investment product and should not be held for longer than a few weeks or months. If you hold them for longer than this, you could incur significant losses.
CFDs are a high-risk, high-reward investment product that exposes a broader range of assets than traditional investments. They allow investors to trade on margin, magnifying profits (or losses). However, they are not regulated in the same way as stocks and other traditional investment products and can be expensive to trade. They are a “short-term” investment product and should not be held for longer than a few weeks or months.