The diversified nature of the capital markets makes it possible to speculate on the prices of various securities in search of profits. However, contrary to perception, one does not need to own an asset to profit from it.
Contract for Difference are instruments that allow people to speculate on price changes. Unlike stocks, one does not need to own an asset. Instead, one only needs to be accurate in which direction rate will move profit conversely from changes in rates.
The difference between the entry and final price amounts to profit. Likewise, the total amount of gains depends on the units purchased. The value of each unit varies across various security classes. For instance, 1000 units on a currency pair could be worth $10.
Being some of the most speculative instruments, they remain banned in some countries, including the US.
What you should know
CFDs are simply agreements between two people, one on the buy-side and the other on the sell-side. Whenever you purchase, you are merely looking to gain on the rate edging higher, with the gain being the difference between the entry rate and the final.
Similarly, when one sells, they are simply looking to profit on price tanking. If the final price is much lower, the gain is the difference between the much higher selling price and the final price.
With these securities, you are not investing. Instead, you are entering into a contract agreeing that the price will likely move in a given direction. Upon closing a position, people exchange the difference in asset prices.
If a person was to buy Puration stock at $2 and it increased to $4, the $2 increase will be the price difference. If they purchased 1000 units valued at $0.01 each, the total gain would be $10 x 2 = $20.
How to trade CFDs
It starts with opening an account with a broker to access various derivative instruments. Besides, you must deposit some amount to access leverage that magnifies the purchasing power making it possible to buy more units of any underlying assets.
With the account setting process complete, the next step entails selecting an asset to speculate on. Given that there is no actual owning, brokers offer an array of assets to speculate on, ranging from indices to forex and stock stocks and commodities.
Upon selecting, enter a buy or sell. Remember, gain or loss will be the difference between the entry and final cost multiplied by each unit’s value.
Risk management is crucial, given that such products are highly speculative. Likewise, the use of stop-loss orders is crucial to mitigate against a trade going south.
The costs
Costs vary from one broker to another. Some tend to charge a commission for opening and closing positions, while others don’t. One is charged a commission on trading derivative shares, while forex and indices are commission-free in most cases.
Likewise, there is usually a fee for holding a position overnight. The CFD holding cost is triggered whenever a position is left to run overnight. In most cases, the cost is charged based on the interbank rate of the asset under consideration.
Why CFDs?
They have become increasingly popular thanks to the minimal fees they come with backed by some of the highest margin percentages. They also stand out in part because they allow people to profit from price changes. Likewise, one does not struggle with owning anything.
Speculating on these instruments is pretty simple as one only requires to deposit a small amount. Leverage offered enhances purchasing power, conversely making it possible to buy more units for enhanced profits.
Unlike other products, CFDs come with some of the lowest commissions. Also, there is no limitation on the number of units one can buy. In contrast, one must have more than $25,000 in the account to buy the same stock three times in the US.
They also stand out as they allow people to profit on the rates moving up or down. When prices are declining, it is still possible to profit through shorting. However, that is not always the case with stocks in some markets.
Drawbacks
Wide spreads on underlying assets are one of the biggest drawbacks with some assets, limiting the number of profits one makes. During a volatile session, the difference between the buy and sell can be much wider, requiring huge price moves for one to generate significant returns.
Some countries prohibit CFDs. The unregulated nature of the instruments has seen some regulators impose bans, such as the US. However, a good number of countries don’t have prohibitions led by the UK and Germany.
As is the case with other instruments, it is still possible to incur significant losses with these products, especially when on margin trading. While leverage in CFD trading can magnify profits, it is also a double-edged sword that magnifies losses whenever price starts moving in the opposite direction.
Bottom line
CFDs are among the most popular financial instruments as they allow people to profit from price changes on various assets. Unlike investing, these instruments allow people to generate significant returns without owning anything, therefore avoiding unnecessary costs.
People only have to speculate on prices, whether moving up or down. With the help of leverage, only a small amount of capital is needed to purchase or sell a good number of units for magnified profits.