CFDs, or Contracts for Difference, are financial derivative products that enable investors to speculate on financial markets without owning the underlying asset. They're a contract between a buyer and a seller that stipulates the seller will pay to the buyer the difference between the current value of an asset and its value at contract time. If the difference is negative, then the buyer pays the seller. Essentially, it allows traders to take advantage of prices moving up (long positions) or prices moving down (short positions).
Here's how CFD trading works:
- Choosing the Market: First, the trader chooses which market they want to trade in. This could be a currency pair in the forex market, a commodity, stock, index, or bond. The choices are extensive.
- Deciding to Buy or Sell: If the trader believes the price of a chosen asset will rise, they would 'go long' (buy). If they believe the price will fall, they would 'go short' (sell). For example, if you think the price of gold will rise, you might decide to buy a gold CFD.
- Determining the Trade Size: CFDs are traded in specific quantities. In the case of equities, this would be the number of shares, in the case of indices or commodities, this could be a certain quantity or number of contracts. The larger the trade size, the larger the profit or loss for every point movement in the underlying asset's price.
- Applying Leverage: One of the major attractions of CFDs is the ability to leverage your investment. This means you only need to deposit a percentage of the full value of the trade to open a position. For instance, if the margin requirement is 5%, you would only need $500 to trade $10,000 worth of contracts.
- Monitoring and Closing the Position: Once the trade is open, profit and loss will fluctuate with the movements of the underlying market. You can monitor this in real-time and, if you believe the market is going to turn against you, you can close the trade to limit losses. Similarly, if you're happy with your profits, you can close the position to lock them in.
Trading CFDs comes with several advantages, including the ability to leverage, access to global markets, and the ability to go long or short. However, it also carries significant risk. The use of leverage can magnify profits but also magnify losses, potentially even exceeding the initial deposit. Additionally, because you don't own the underlying asset, you miss out on certain benefits such as voting rights for shares or dividends. Finally, CFD markets can be highly volatile, and prices can change rapidly, leading to unexpected losses. Therefore, it's essential to understand the mechanics and risks before engaging in CFD trading.