CFDs (Contract for differences)
The acronym CFD stands for Contract For Difference. A CFD is an agreement for the difference (in terms of a gain or loss) between the opening and closing prices of a position of a given financial instrument.
Contracts for difference reproduce the price movements of their underlying assets and allow you to speculate on an increase or decrease of the price while using leverage.
CFDs are key tools, especially for short-term investors who want to sell short when the markets pull back.
It is an efficient way to use capital, as the funds can be invested in a wide range of products.
There are several types of CFDs:
- CFDs for commodities (soybeans, wheat, oil, etc.)
- CFDs for foreign exchange (contracts that follow currency pairs)
- CFDs on indices (DAX, CAC40, S&P500, etc.)
- CFDs on shares (contracts that follow the shares of listed companies)
The price of a CFD reflects the actual price of a share because the value of a CFD is based on the underlying asset.
However, you do not physically hold the stock, so what is the point of buying a CFD if you can directly buy the asset itself? The main reason is that CFD margins are smaller, which means that you don't have to use as much money to control the asset.
Most CFD brokers allow you to invest with a 5% margin. For example, you can buy 100 shares at a price of $25/share for a total value of $2,500 with just $125. This leverage effect helps increase the size of your investments, but it also increases the risk of losing your money quickly. CFDs are therefore highly speculative products that are reserved for sophisticated investors.
CFDs allow you to trade on all stock exchanges from the comfort of a single broker platform. The fees you are charged therefore tend to be much lower than what you would otherwise pay using a traditional stock broker. The rules in the CFD world are simplified, especially for short selling (to bet on the decline of an asset), because you do not own the underlying asset, so you can trade on the rise or fall of an asset at any time.
Everything seems too good to be true, and it is true that CFDs represent a huge investment opportunity, but there are also risks. To be profitable, a CFD trader needs to be experienced, as 90% of beginners lose money.
Advantages of contracts for difference
- Diversifying a portfolio with little capital
The use of leverage allows you to multiply your initial investment (including your gains or losses) and you can therefore trade a complete portfolio that includes stocks, indexes and commodities without having to block large sums of money.
- Selling short
By using short positions, you can profit from negative price variations. This technique is also known as "protection", or "hedging". It is particularly useful for shielding your portfolio from a drop in the market.
- No taxes
CFDs do not give you any ownership, so they're not considered assets. Therefore, you don't pay any taxes when financial instruments are sold since you never actually bought them.
- Trading at a low cost
Transaction costs are included in the difference between your purchase price and the selling price (the spread). Fees for CFD transactions are therefore lower than those of regular securities.
- You get to decide when you close your position
Unlike futures and certificates, and other derivatives such as warrants and options, CFDs don't have expiration dates, you can close a position at any time.
- CFDs are negotiated with real-time prices
Variations in the price of a CFD are identical to the variations of the underlying stock or index, and they are calculated in real time. Transactions are processed immediately with no delays, and any gains or losses are also credited or debited in real time.
Reasons why you should not invest with CFDs
If you don't understand the basic mechanics of the markets, don't add CFDs to your portfolio. You need to fully understand the basics of buying and selling in the markets. If you don't understand this, start with a demo account, most CFD brokers offer free demo accounts.
If you are unaware of the dangers of leverage. One of the most common mistakes that new traders make is to underestimate their exposure. If you close a profitable trade, the leverage will boost your earnings, but if you lose, it will increase your losses. 90% of beginners lose all of their money because they have not correctly taken into account the impact of leverage on their positions and have failed to manage their risks accordingly.
If you are driven by your emotions. This is where many investors - and even experienced investors - can go astray. Emotions have no place in highly speculative investments. You need to create a compelling global strategy and have the discipline to strictly follow it, regardless of what you feel emotionally. You must be able to close a losing transaction without any emotional attachment. Build your strategy according to your risk tolerance, and then stick to it.