What is CFD Trading?
Contracts for Difference, or CFDs
Here we are going to take a look at Contracts for Difference (CFD); their history, what they are and what CFD trading entails, looking at the advantages for the individual trader or investor.
For the retail trader or investor and individual market participant, the trading and investing world have expanded in the 21st Century to offer opportunities that were unthinkable in the latter 20th Century. These advances have been aided by technology improvements, the openness of financial markets and the better education of the trading and investing population, as well as the development of markets in CFDs.
Advantages of CFD Trading
There are three key advantages for trading using CFDs:
- The ability to have short and long exposure
- The capacity to trade with leverage, on margin
- The ability to hedge
What are CFDs, and what is CFD trading?
A Contract for Difference (CFD for short), is a derivative product, meaning that CFDs are derived from core financial market assets. These assets could be Forex (FX or currencies) individual stocks, share indices, commodities or maybe bonds. A CFD lets the investor or trader speculate on the price of these assets, but without actually owning the underlying asset.
CFDs: A brief history
CFDs were developed in the 1990s in London and were originally designed for institutional investors. They were intended to allow investment and hedge funds to leverage their market exposure (we will discuss leverage below) and also to hedge their positions (again, hedging is examined later).
In the late 1990s, though, CFDs started to be used by retail brokers to allow individual traders and investors to trade and invest in numerous asset classes. As a result, it enabled individuals to trade multiple markets and assets, to “go short” of these assets, whereas before it was only really feasible to buy and own assets (to “be long”).
Furthermore, retail brokers offered trading on margin to retail investors, allowing capital and funds to be leveraged. Hantec Group has been providing wealth management services to help its customers create and accumulate wealth since 1990.
1. Short and long exposure
As with any other market, when trading a CFD you have the option to either buy or sell the CFD at the current market price. The broker (Hantec Markets) will offer a market in the CFD, a bid price (the sell price for you) and an offer price (the buy price for you). The difference between the bid and offer price is called the spread. If you believe that the underlying financial market asset on which the CFD is based is going to go up, you would buy the CFD. Equally, if you think that the underlying asset is going to go down in price, you would sell the CFD.
The dynamics are just the same as trading any other market. If you buy the CFD and the market goes up, when you come to sell the CFD to close the position, you will realise a profit. But if you buy and the market goes down, when the position is closed, and the CFD is sold, you will incur a loss.
Similarly, if they sell the CFD and the market falls, when they come to buy back, they will realise a profit, but if they sell and the market goes up when the position is closed, and the CFD is bought back, they will incur a loss.
The easiest way to comprehend the idea of margin and leverage is to look at an example. Let’s look at the price of Gold and see how leverage work when trading or investing in CFDs. If you thought the price of Gold was going to go up, you could either buy physical Gold or buy the Gold CFD (where you would NOT own any Gold).
If you had $10,000 in an unleveraged investment account and Gold was trading at $1,000/oz, then you could buy 10oz of Gold, which would use up the full $10,000 in your account. But if you used the same $10,000 to buy a Gold CFD, that is traded on margin (with leverage), you would not need as much in your account, to buy the equivalent 10oz.
For example, if the leverage was 5 times, this means you would only need 20% of the value in your account. So, you would need just $2,000 to buy 1 oz of Gold. So, with a $10,000 CFD account, it would be possible to buy 50 oz of Gold in terms of CFDs. So, the leverage for the CFD account is 5 times the normal unleveraged investment account.
This concept of leverage means that if Gold doubled in price from $1,000/oz to $2,000/oz and you invested via an unleveraged investment account, you would profit in this unleveraged account with a 100% profit of $10,000.
For the CFD account, however, you could have bought 5 times the amount of Gold, so on a move up from $1,000/oz to $2,000/oz, you would return a 500%, so $50,000 profit. This is an advantage of trading with leverage or on margin.
Please do remember though: if the Gold price had fallen by 20% to $800/oz, in an unleveraged account, the value of the account would fall from $10,000 to $8,000. For the same trade with a CFD account on 5 times leverage, the account would have been wiped out, a 100% loss, $10,000 lost. Trading CFDs on margin with leverage means potentially bigger rewards, but this comes with possibly more significant losses.
Another advantage of using CFDs for investors (as opposed to traders) is regarding hedging. A hedge is when an investor wants to lessen their risk to possible future market moves. This action can be done by counteracting their market exposure with an opposite position in a very similar market.
Let’s use the example that you have a portfolio of investments in a variety of German stocks but were worried that a number of these stocks or the broader global stock markets were at risk of for a short-term downside correction. You could use CFDs to offset that threat. You may choose to sell the CFD on the German stock index, the DAX (the GER 30 with Hantec Markets). If the broader market fell in value, then the losses in the stock investment portfolio could be fully or partially counterbalanced by profits in the short GER 30 CFD. If the stocks went higher in value, then the two could offset again. So a possible profit on the stocks would have been lost, but the risk would have been limited or hedged.
So, now you have a better understanding of CFDs, maybe it is time to open a Demo Account with Hantec Markets!