The name of CFDs comes from the acronym Contract For Difference. It is a financial contract between two parties, one of which is defined as the “buyer” and the other as the “seller.” It implies the seller will pay the buyer the difference between the price of an underlying asset when the contract started and its value at a later date.
CFD is, therefore, a derivative financial product. It allows you to bet on the upward or downward trend of a share or a stock market index (more rarely, a currency or a commodity) without having to buy it.
For each price change point in favor of the buyer, the profit is equal to the number of units subscribed multiplied by the number of price change points. For each unfavorable price point, the buyer suffers a loss, and the seller takes the difference.
Types of CFDs
CFDs allow you to make profits indexed to changes in the price of the underlying. The underlying can be a stock, commodity, indices, or currency.
Regarding the currencies, we are talking about trading the Forex (Foreign Exchange), the largest financial market. But it is possible to trade CFDs on stocks, for example, on the CAC 40 or some other stock market indices. In case the underlying is stock, the contract is an equity derivative allowing investors to speculate on stock price movement without buying ownership of the stock.
CFDs are also available for commodity trading in gold, silver, oil, or any other commodity in the financial markets.
CFD trading is accessible to individuals through the services of specialized brokers and their online trading platforms. Brokers charge commissions on each transaction. These can include the spread (price difference between the purchase price of the product and the sale) or even a maintenance margin for those who hold their positions for a long time.
Trading CFD with the leverage
CFD trading also enables you to benefit from the leverage effect, that is to say, to take a trading position for an amount exceeding the sums actually available in your account. This effect allows you to multiply your gains, exposing you to the risk of increasing your losses. So beware that you can lose more than the money you put in your account at the beginning.
How to trade CFDs?
CFD trading is accessible to individual traders. It requires the use of the services of a specialized CFD broker. Most of them offer their services online. Brokers take commissions on each transaction. Therefore, these costs are deducted from the profits made on each transaction (or increase your losses, if applicable).
The operation of most brokers is such that if a trading position stays open after a trading day, the account will be updated automatically on a daily basis. Thus, in case your investment is a winner, the broker will pay the sum corresponding to the daily profit into your account. Otherwise, he will deduct the amount corresponding to the day’s loss from your account.
You can buy or sell as many CFDs as you want. You can also use the leverage effect. That is to say, take a position for an amount greater than the sums available in your account. Sometimes the amount could be 20 times greater. It is a system that allows you to multiply your gains.
But it also could expose you to the risk of multiplying your losses or even losing more money than initially placed in your account. It represents a significant risk of which we must be aware. Moreover, as the investor needs to keep a quantity of liquidity in his account to cover the leverage effect, he or she may be required to return money if the evolution of trading positions requires so.