What is Contract for Difference (CFD) in trading?
A contract for difference (CFD) is a type of derivative instrument that allows two parties to enter into a contract to trade the underlying asset at a specified price. The underlying asset can be any specified financial instrument, including stocks, bonds, commodities, foreign exchange, and even cryptocurrency.
The main benefit of CFD trading is that it allows traders to speculate on the price movement of an asset without actually owning the asset itself. This means that traders can take a position on both rising and falling prices.
CFDs are traded on financial instruments, including stocks, commodities, currencies, and indices.
CFD trading is a popular way to trade the markets, as it offers several advantages over other types of trading. These include:
– Leverage: CFDs are traded on margin, which means that traders can take a position with less capital than if they were to trade the underlying asset directly. This allows traders to leverage their capital and potentially make larger profits. However, it also means that losses can be magnified, so it is important to use leverage carefully.
– Shortselling: CFDs allow traders to take a short position on an asset, which means that they can profit from falling prices. This is not possible with traditional investing, where traders can only buy assets and hope that prices will rise.
– No stamp duty: In the UK, CFD trades are exempt from stamp duty, which is a tax on the purchase of certain financial instruments. This can save traders a significant amount of money. Be careful to check the tax rules in your jurisdiction – I can’t offer tax advice though I have a helpful guide in Australia here.
CFD trading does have inherent risks, which need to be considered before taking a position. These include:
– Market risk: The value of an asset can move up or down, and CFDs are traded on margin. This means that a small movement in the price of the underlying asset can result in a large loss (or gain) for the trader.
– Liquidity risk: CFDs are traded on leverage, which means that a small movement in the price of the underlying asset can result in a large loss (or gain) for the trader. This can be magnified if the market is not liquid and prices move quickly.
– Counterparty risk: When trading CFDs, traders are entering into a contract with the CFD provider. If the provider becomes insolvent, then traders may not be able to close out their positions or may only be able to do so at a loss.
CFD trading can be a great way to make profits from the markets, but it is important to understand the risks involved before taking a position. Use this simple outline to understand more about how CFDs work and how they can be traded.