What is a CFD? pros and cons of CFD trading

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Updated on July 6, 2024 Trading on the stock exchange is no longer the preserve of banks, multinational corporations and other large companies. Exactly opposite. Derivatives trading is now very ... Read More

Updated on July 6, 2024

Trading on the stock exchange is no longer the preserve of banks, multinational corporations and other large companies. Exactly opposite. Derivatives trading is now very popular among small traders. They try to gain from the estimate of the further development of the price of the underlying asset. CFD trading offers investors plenty of brokers. You can close trades with them on all possible assets. All you have to do is choose the CFD asset that you think is the most promising. You don’t know what a CFD is? So come and meet him.

What is a CFD?

Investing in CFDs is simply more practical. Imagine that as a trader you find that now is a great opportunity to invest in wheat. You follow the development of the market and it is clear that its price will rise. Therefore, you decide to buy 20 tons of wheat and sell it when the time is right. But can you imagine 20 tons of wheat being dumped in front of your house? Do you have room to store it before you take it to those who buy it from you? And will you have the technology to transport it?

We dare say that as a small trader you don’t want or even can’t arrange any of this. And that’s why CFD trading is here. CFD contracts have also allowed traders who would like to invest based on an estimate of the rise and fall of the prices of various assets to enter the market. And it is on this principle that CFD trades are built. Whether it is the already mentioned commodities, crypto, forex currency pairs, shares or indices. Just buy or sell CFD assets and there is no need to solve anything.

So what is a CFD? CFD, or Contract for difference, means a contract for the settlement of differences. It is a contract that two parties enter into when trading financial derivatives. Both commit to equalize the difference between the entry and exit of the trade. This can mean profit or loss for the CFD trader. It depends on how well the development of the price of the underlying asset will be estimated.

Derivative and underlying asset

You already know what CFD is. Let’s say something more about two terms that are central to CFD trading. These are the derivative and the underlying asset CFD. Simply put, a derivative is a derivative of an underlying asset. The underlying assets are any assets whose price you will want to trade. You can choose whatever your broker offers that suits you. It can be the already mentioned wheat, oilBitcoin … Just anything. There are no limits to CFD transactions.

But you will not close trades with real assets when trading CFDs. Only with their derivatives. At the same time, their price will move in the same way as the price of the given asset. Therefore, you cannot realistically expect 20 tons of wheat, nor that US dollars will come to your account if you buy them on Forex .

But the little trder is not worth it. He decided to only estimate the future development of the price. And he will either make money on it, or, on the contrary, lose money. If he has guessed the price movement correctly, the other party will pay him the price difference. This means profit for him. If, on the other hand, he made a mistake in his estimate, he must pay the difference to the other party. In that case, he loses. This is the principle of this way of trading.

CFD trading

Investing in CFDs has its specifics. And you should know about those. Therefore, let’s now say something about the basic principles of CFD. Every investment carries some risk. And therefore, before the CFD assets completely engulf you, prepare well for it. It is ideal to create a demo account for this purpose. These are offered by most brokers today. And it’s free. It will allow you to familiarize yourself with the basic rules for investments. You get a virtual currency with which you can close trades based on your estimate of the market development. Today we will introduce you to at least two basic principles for CFD trading. It is the leverage system and also the possible positions you can enter.

Lever system

When investing in CFDs, you should consider a leverage system. The point is that it is not necessary to have the full amount to cover your order to enter the position. This means that you only need a certain percentage of the full price to buy the given CFD asset. This initial investment of yours is called margin. So if you close the trade with 1:15 leverage, the total order volume will be 15 times your margin.

Sounds like an advantage so far, right? But what if we told you that it is also 15 times higher risk? Trading with leverage means that your profits and losses will also multiply. Therefore, if your estimation of price movements is successful, your profit will be several times higher. But if you make a mistake and close a CFD trade that is not suitable for you, your losses will also be multiplied. So your profits and losses from the trade afterwards will be many times higher than your original margin.

Therefore, CFD assets can make you a fortune or, on the contrary, make you rich. It will certainly be an advantage if you are a successful CFD trader. Otherwise, it can be a problem. The advantage certainly lies in the fact that when investing in CFDs you can earn quite well even on smaller trades. And the same goes for small price movements. Therein are the advantages of this type of trading.

So if you want a career as a professional trader, leverage will be very important to you. While the leverage for retail traders is limited by the authorities, many brokers accommodate professional traders and let them increase their leverage. However, it is necessary to prove that you are a trader with experience and know how to navigate the world of business. 

Position with CFDs

The important thing about CFD assets is that, as a trader, you can profit not only from the rise, but also from the fall in price. With CFD trades, you can hold two different positions. Depending on whether you want to speculate on the growth of the asset’s price or, on the contrary, on its decline, you will enter a certain position. You have the option of choosing between a short and a long position.

If you open a short position, you will be speculating on a drop in the price of the given CFD asset. It means that you start selling an asset that you don’t really have. So you have to borrow it from the broker or one of his clients. On the other hand, when you start a long position, you are speculating on the rise in the price of the asset. So you are entering a selling position. In CFD trading, the long and short position has nothing to do with the length of time the position is held. You can hold CFD assets for as long as you want.

At least if you have enough money in your account. And that’s for the case of pro-business CFD trades. Otherwise, the broker will prompt you to top up the margin. And if you don’t, the broker can close your position himself. If, on the other hand, you top up the margin, you retain the position of buying or selling CFD assets.

How to start trading CFDs

Today, everyone can invest in CFDs. All you need is a computer and a network connection. CFD assets are offered by a large number of CFD brokers today. Creating an account takes only a few minutes, and all you need to do is fill in your email address and choose a password. This will open a demo account, which is especially useful for traders without experience. But also for professional traders. Thanks to the demo account, they can try whether investments with the given broker will suit them.

Actions

What is a stock CFD? That being said, some brokers allow you to choose between investing in physical shares and CFD assets. The basic difference between them is clear. While when you buy a physical share the security really belongs to you, in a CFD trade the share is only the underlying asset. And you speculate on the development of its price. But what about dividends and the right to vote?

CFD shares do not transfer the right to vote to the trader, as is the case with a physical share. Therefore, you do not become a real shareholder who is entitled to participate in the further development of the company. The opposite is true for dividends. The CFD share holder is also entitled to dividends. That is, if the given company pays them.

The pros and cons

Now you know what CFDs are. So are these assets worth investing in? There is no clear answer to this. It has its pros and cons. The decision itself is up to you. However, it is certain. That this way of trading is now very well known among small traders. Not even when CFD assets opened the gate for them to enter the world of business. So let’s recall the main pluses and minuses of CFD assets.

AdvantagesDisadvantages
You don’t own real assetsLoss of rights to underlying shares
The leverage system increases profitThe leverage system increases the loss
Mostly commission-freeHigher spreads
Just a percentage of the store price is enoughWeak regulation
Unlimited position holding time 
Earning even with a small order volume 

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