What are CFDs?

2011-04-18T05:58:00.000-07:00

Allow me to introduce the humble CFD. Many of you have heard of them, or seen them on your brokerage software. What are CFDs? How do they work? Who should consider trading CFDs? What advantages do they have? What are the risks involved? These are the questions which shall be answered if you continue reading.

What are CFDs?

CFD stands for Contract for Difference. What this means, is the buyer enters an agreement to exchange the difference in value of a particular financial instrument (e.g. shares, commodities, forex), between the time at which the contract is opened and the time at which it is closed.

There are several great advantages of trading CFDs. For one, CFDs are traded on leverage. So you don't actually have to put up the money for the entire value of the asset. But you are exposed to the entire price change. This gives you much more 'bang for your buck'. Unfortunately, this also means that if the market goes down, you are in for much greater losses.

This may sound complicated, but in practice it is quite simple. You never actually own the derivative you are trading. You either make or lose your money by the price movement.

Lets go through a simple example.

You buy 1000 Shares CFDs in company X, valued at $15/share with a margin requirement of 5%. Therefore, upfront, you pay: 1000 x 15 x .05 = $750.

Now lets assume the company goes up in price by $1, and you end the contract. You end up with a profit of:

1000 x 1 = $1000

with a margin of 5%, you have a leverage of 1:20, therefore:

1/15= 6.7%

6.7 x 20 = 1.3

1.3 x 750 = $1000

Not bad for your initial investment.

Just remember, it is important never to underestimate the market's ability to go down hill, in which case, your potential losses will be amplified just as much as your potential gains.

Make your own choices.

Weekend Trader.

The Weekend Trader

What are CFDs?