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A relatively new form of financial trading, contract for difference (CFD) trading is certainly one of the hotter trends filling investors’ pockets at the moment. CFDs have been around since the early ‘90s, but only in the last decade has this unique type of financial derivative really taken off. If you’ve heard of CFDs, available through the likes of III, in passing, skimmed over news articles on the topic or feigned knowledge of them in conversations with finance-savvy colleagues, now’s the time to take a longer look at whether CFD trading could benefit you.
It may seem complex initially, but CFD trading is far more straightforward than you’d think. Here’s a brief guide to the basics:
What exactly are CFDs?
A contract for difference is exactly what it sounds like. It’s an agreement between a buyer and seller wherein the seller pays the buyer based on the amount an asset’s value has varied from the point of sale to the end of the contract. However, if the asset’s value has decreased (i.e. if the difference is a negative number), then the buyer must pay the seller the difference.
What makes CFD trading different?
Unlike with traditional financial trading, CFDs don’t require you to actually own the underlying asset you’re trading. Instead, you’re merely wagering on the amount a financial asset or market will change in a given time. It is because of this that CFD trading allows you to benefit from falling markets as well as rising markets. As opposed to the standard buying and selling of stocks/shares, if you choose to ‘sell’ a CFD (aka ‘go short’), you actually want prices to fall – you are hoping for the market to do worse. In this sense, CFD trading is recession-proof.
What are the pros and cons of CFDs?
CFD trading has several benefits. In addition to allowing you to profit from falling markets, it’s worth noting that CFDs can offer far greater returns on your initial investment. Unlike traditional trading, you don’t actually need to put up the full value of the share you’re trading, but a much smaller deposit amount (known as a ‘margin’). This frees up more capital for you to carry on with other investments.
Another benefit of CFDs is that no earnings are subject to stamp duty. CFD trading is also far more accessible and fast-paced than other forms of trading, eliminating the need to work through a stockbroker.
A potential disadvantage of CFDs is that, just as it’s possible to earn far greater returns on your investment, so too is it possible to lose far more from a single deal. ‘Over-leveraging’ is a major mistake of novice CFD traders, and it’s certainly something to watch out for. Another downside of CFD trading, as opposed to traditional financial trading, is that you have no traditional ‘shareholder’ voting rights. Whereas large shareholders of certain companies are often able to vote on policy decisions and have a certain influence on the company’s future direction, no such privilege is afforded to CFD traders. You are entirely at the whim of the market
Inevitably, investing is well-reasoned risk-taking. Without risking something, you don’t stand to gain anything. As with all types of trading, the key to success with CFDs is to balance the risks against the potential rewards and act accordingly.
Graeme Davidson is a keen online investor and has been trading online for nearly 10 years
Image by Images Money used under creative commons licence
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