How does a CFD work?
A Contract for Difference (CFD) is essentially an agreement between a trader and a broker or bank. At the end of the contract, the parties exchange the difference between the opening and closing price of a particular financial instrument, such as a stock or DAX index. It is important to emphasize that at no time do you own the physical value, i.e. the stock itself.
CFDs are leveraged products. This means that the money you invest is usually only a fraction of the market value of the stock (or other value). This is referred to as margin trading. This means that CFD trading is not only available to large investors but is also suitable for small investors.
A difference contract is also a very popular form of derivatives trading. Unlike equity trading, CFD trading enables you to speculate on the rising or falling prices of the fast-moving global financial markets (or instruments) such as equities, indices, commodities, currencies and treasuries. You can also use CFDs to hedge an existing physical portfolio to protect against high volatility.
How does CFD trading work?
When opening a CFD position, you first select the relevant market and the number of CFDs you wish to trade on the trading platform (e.g. Metatrader). The profit increases with each point as the market moves in the desired direction. Of course, the same applies vice versa, meaning that losses are incurred should the market develop in the opposite direction.
Example: If you think that the oil price is rising, you can place a buy order to trade 5 CFDs at a price of 4933 USD. If the market rises by 30 points to 4963 USD and the position is then closed, there will be a profit you closed your position, you would make a profit of 150 USD, 30 times the 5 contracts you bought. However, if the market moves in the opposite direction and the oil price drops 30 points to 4903 USD, you lose 150 USD.
CFDs as hedging instruments
Since CFDs can be used to go short and long (also simultaneously), these products are also used as “insurance” to compensate for losses in a physical equity portfolio.
If, for example, you hold many Dax shares and fear that the markets will fall, you can enter into a CFD short trade on the Dax to protect the equity portfolio and benefit from falling Dax prices. If the Dax share prices were to fall, the loss in value of your equity portfolio would be offset by a gain in the CFD short trade. In this way, you can protect yourself without having to bear the costs and inconveniences of liquidating the equity portfolio, as these are usually higher than for CFDs.
Why is CFD trading popular with investors?
CFDs are a popular way for investors to actively trade in the financial markets. The advantages of CFDs are:
Unlike equities, the broker only charges a fraction of the cost of opening a trade. There is no commission at all when trading stock indices (Dax). You only pay the spread.
It is possible to speculate on both rising and falling markets.
– Leverage products:
You can spend a small amount of money to control a much larger value position.
– Hedging instruments:
You can use CFDs to compensate for possible losses in value of a physical equity or commodity investment by betting on falling prices with CFDs.
Is CFD trading suitable for me?
CFD trading is ideal for traders who want the opportunity to earn a high return on their money. However, it carries significant risks due to the leverage effect and is not suitable for everyone. It is strongly recommended that you first trade on a demo account before attempting to do so with real money. You should inform yourself in advance about the effect of leverage.
On which CFD markets can I trade?
– Stock indices such as Dax, Jow Jones, S&P 500, Nasdaq, FTSE
– Shares like Google, Facebook, Deutsche Bank, BASF
– Raw materials such as oil, silver, palladium, wheat, cocoa
– Other markets including bonds, interest rates and options
Risk Warning: Trading Foreign Exchange and Contracts for Difference (CFDs) is highly speculative and may not be suitable for all investors. The leverage created by trading on margin can work against you as well as for you. Only invest with money you can afford to lose and ensure that you fully understand the risks involved. You should also precisely inform yourself about all the risks associated with trading currencies and in case of doubt, consult an independent financial consultant.