Introduction to Contracts for Difference – Unlocking The Power of Leverage

An investor must constantly seek ways to maximize profits and navigate the stock market innovatively. There’ll be high levels of growth in the online trading market over the next decade. The combination of Contracts for Differences (CFDs) and eTrading platforms creates a powerful synergy, empowering investors to stay ahead in their games. CFDs have emerged as an attractive alternative that opens more possibilities. 

This article will guide you through CFDs, how they work, and the disadvantages and advantages you can expect when investing in them.

Introduction to Contract for Differences

A Contract for Differences is known as a swap. It bases its value on an underlying asset value, including a market index, shares of stock, a commodity, or other financial instruments. When trading in CFDs, the buyer has to pay the seller the difference between the buy and the selling price and vice versa. The contract binds the buyer and the seller into an agreement regarding the value differences, leading to why it’s called a Contract for Differences. 

CFDs give an opportunity for traders and investors to profit from the price change without having to own underlying assets. Assets’ underlying value isn’t the main point to CFD traders, as it relies only on the entry and exit price changes. CFDs also give flexibility, giving no time or period restrictions and allowing traders to buy and sell short. 

How Contract for Differences work

When entering a Contract for Differences, an investor will enter an agreement with a CFD broker to exchange the changes in the value of a financial product between the entry point and the closing point. The investor won’t acquire physical goods or securities. Investors also will not own the underlying asset but will later earn revenue based on the value change of that asset. 

For example, when investors purchase the contract, they won’t buy or sell the asset; instead, they’ll predict how much the asset’s value will change in a specific time. The value can go up or down, depending on the investor’s decision. 

When the asset value increases, investors will then offer their holding for sale. The brokerage’s account will calculate the entry and exit price differences, representing the net difference or gain from the settled trades. If the traders predict their asset’s value will drop, they can open a sell position. The trader must then purchase an offsetting trade to make their exit point, and the loss margin will be cash-settled through their account. 

With CFDs, it’s important to find a trustworthy broker, click here if you’re looking for one that is considered reputable.  

Long position

When traders believe that their chosen asset’s value will increase in the future, they can choose to open a long position. The trader must buy and hold the CFD contract until the value increases. 

Short position

If the trader predicts that their chosen asset price will drop in the future, they can take a short position. Upon their entry, traders will sell a contract. Then, when the price drops, the trader will buy the contract with a lower closing price to make a profit. 

Pros and cons of Contract for Differences

To get more clarity about the contract, you must know what advantages and disadvantages the trading strategy can bring. Here are what you must be aware of before buying CFDs. 

Advantages of CFDs

The contract allows traders to invest less while aiming for higher profit. Traders will only have to pay a margin of their contract and leverage their investment multiplication. 

As I’ve mentioned above, CFDs don’t require traders to take ownership of the commodity they plan to trade in. CFDs give more opportunities for traders, despite their results of predictions, and provide flexibility for them. With CFDs, traders will have more choices and cut their losses more significantly compared to a regular trading contract. 

CFDs allow traders to trade on margin, so they will require less capital, reducing the opportunity cost of their capital and the borrowing cost. In addition, CFDs only need traders to pay a small fee or no fees at all. This advantage is due to how the brokers will profit from the spread that traders pay. Compared to other trading instruments, like stock, CFDs are less expensive. 

Disadvantages of CFDs

CFDs can be flexible, but there’s only one side of inflexibility in their attached cost. CFDs have entry and exit costs. Therefore, traders looking to make a profit out of small changes in prices won’t receive a benefit from their investments. The margin changes must be big enough to cover the costs for traders to make any profit through CFDs. 

CFDs are also highly risky. The agreement includes leverages that can lead to high profits, but there are two sides to a coin, which can lead traders to a heavy loss. Not to mention, CFDs aren’t tightly regulated. Brokers can’t prove their credibility besides their reputation, so you must be careful when choosing your CFD broker.