Contributed by Ric Spooner, Chief Market analyst at CMC Markets
CFDs are actually quite a simple concept. They allow you to trade on whether the price of a financial instrument like a share will go up or down. The difference between the buy price and the sell price determines if you make a profit or a loss.
CFD stands for “contracts for difference”. They are called contracts because that′s what they are: a contract between you and the service provider to pay or receive that price difference depending on which way the market moves.
So why use CFD′s and not just trade the financial instrument itself? Here are some of the things to be aware of in deciding if CFDs might be right for you
Trading markets both ways. One of the potential advantages of CFDs is that you can trade both long and short. This is not always easy with some underlying instruments like shares. Shorting allows you to make money out of falling markets. Your initial transaction is to sell. If the price falls you make money but if it rises you lose.
Cross market opportunities and trading tools. Many CFD platforms give you easy access to trade thousands of different instruments across the globe via your computer or mobile phone. There are CFDs over stocks on all the leading international exchanges, share indices, foreign exchange and commodities. CFD platforms also provide trading tools like streaming news, charting and account monitoring.
Leverage and money management. With CFDs you don′t pay for the underlying instrument because you are not taking ownership of it. Instead you are required to set aside an amount in your account to provide some security for payment of the loss if the price moves against you. This is known as the margin. The margin needed is often only a small fraction of the overall value of what you are trading. Using leverage can magnify your returns – and your losses! A 1% market move on an instrument with a 1% margin requirement means a return that′s 100% of the margin you put up. This can be good if you make profits but bad if you make losses. Risk management becomes essential and most successful traders have a lot more than the minimum margin requirement in their trading account.
There′s a lot to know. While the basic concept of CFDs is simple, the underlying instruments are usually not. CFDs aim to replicate the underlying financial instrument such as shares or foreign exchange. You should always have a good understanding of how these underlying markets and the CFDs over them work.
Trading is not the same as investing. CFDs are normally used for trading. This involves different skills to investing. For example trading is often much more short term and traders usually need to be prepared to cut losses quickly. Whether they use CFDs or trade the underlying instrument, successful traders need to develop skills.
Not for everyone. Trading inevitably has its ups and downs. While it can be profitable, it′s not for everyone. At the end of the day a CFD position is not always the same as owning the underlying instrument. It may for example have different tax consequences. Whether trading CFDs is right for you will depend on what you want to achieve as well as on your circumstances and tolerance for risk.
About the Author:
Ric Spooner is chief market analyst at CMC Markets, and has over 30 years experience working in financial markets. CMC Markets has been at the forefront of trading innovation since 1989, offering online platforms for both share traders and CFD traders. CMC Markets holds CANSTAR′s five star award for best value Australia online share trading.