Contracts for Difference (CFD): The ultimate user’s guide for the modern trader
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This explainer is brought to you by Capital.com Australia (AFSL 513393), a multi-award winning global investment trading platform.
Along with buying and selling shares, there are other investment strategies traders use to profit from the movement in stock prices.
And one of the most common are CFDs (contracts for difference).
In terms of their practical application, CFD strategies are more complex than, say, simply buying physical shares.
But for savvy investors, they also offer plenty of trading advantages. In this user guide, we’ll break down what CFDs are and why traders use them to maximise returns.
A CFD is a contract between a trader and an authorised CFD broker. CFDs give traders a vehicle to build an investment position based on the movement of an asset’s price – both up or down.
A CFD holds the same price as its underlying asset. When trading in CFDs, investors are not trading the underlying asset but speculating on the future price movements of that asset.
The key distinction between a CFD and a direct investment is that the trader can benefit from movements – up or down – in asset prices without ever owning the underlying asset.
A key feature of CFDs is that they provide an established structure for traders to take an investment position based on whether the price of the asset will rise (long) or fall (short).
Traders can execute buy orders if they think the value of an asset will go up, or sell orders if they think the value will fall.
A second key feature of CFDs is that traders can use leverage.
Say a trader wants to buy $1,000 of Brent crude oil. Using a margin loan account with a traditional brokerage, they’d typically require around 50% of the funds up front ($500).
However, CFD brokerages offer higher leverage. In turn, if the CFD broker offered 1:10 leverage, the trader could speculate on the price movement for $1,000 worth of oil for an upfront cost of only $100 (1,000 x 10%).
Suppose a trader wanted to buy 100 shares in a company using CFDs because they think the price will go up from $50 to $55.
Using a 1:10 leveraged CFD trade, they could buy exposure to the $5,000 investment for a $500 outlay. If the price went to $55, the contract would be met. The trader would make the difference as profit,
Conversely, say the trader is watching the stock and they think it will fall from $50 to $45.
Using the same amount of capital upfront, they can open the trade by selling the stock at $50, then close the trade by buying the stock at $45 – for the same profit of $5 per share.
As outlined in the example above, CFDs provide the opportunity to generate increased leveraged returns with lower upfront capital costs, and without owning the underlying assets outright.
Another advantage is that CFD brokerages such as Capital.com give investors around-the-clock access to global markets across multiple asset classes, all through the one platform.
CFDs also provide access to traditional investments with much lower entry levels, noting however that leverage also exposes investors to a faster loss of funds in the event of an undesirable price outcome.
For example, on Capital.com, some traders maintain open positions valued at more than $1m, based on the future direction of different assets. However, traders on the platform can also execute CFDs with a minimum outlay of just $20.
Typically, CFD brokerages also allow all clients to day-trade without maintaining minimum amounts of capital or daily limits on the total number of trades.
In addition, CFDs also provide traders with a much wider investable universe. Common asset classes where CFDs are used include Australian and global shares, currencies, cryptocurrencies, commodities and indexed securities.
While leveraged trading can significantly amply returns, there is also increased risk and complexity to trading CFDs.
Using the Capital.com platform, traders can utilise a number of strategies to mitigate their downside risk.
One common practice is the use of stop-losses and take-profit orders. Implementing a stop-loss means that if a trade goes in the wrong direction, it automatically closes out the trade at a set price designated by the trader, to limit further losses.
In addition, take-profit orders foster trading discipline by allowing the trader to realise profits at the set level they selected in advance. These measures help secure profits, instead of allowing the trade to run on and potentially decline in value later.
Capital.com, like all ASIC regulated brokers, also provides traders with negative balance protection, so traders will not lose more money than what they initially deposited.
Typically, traders maintain a buffer in their account to keep their leverage credit, otherwise a ‘margin calls’ is triggered if a leverage trade goes over the margin in the opposite direction to what they expected. This is where traders will either need to top up their balance or close some some of their positions.
A third common risk strategy is hedging. Because CFD investments are more flexible, it’s common for traders to ‘hedge’ their view on the price direction of a specific asset by executing a separate CFD in the opposite direction (i.e. long-short), which helps to reduce losses if their initial thesis proves incorrect.
Taken in aggregate, we can see that CFDs provide exposure to a wide range of asset classes, with lower up-front capital costs than traditional stock trading.
At the same time, effective risk management strategies are best implemented by trading on established platforms such as Capital.com.
Along with offering up to 30:1 for retail investors and 200:1 leverage for CFD trades with professional accounts, Capital.com also provides traders with a leading financial markets news feed based on multiple sources and AI data, to help give traders an information advantage.
Capital.com also allows traders to manually select the leverage from 1:1 all the way to the max leverage on the instrument.
Capital.com is licensed by the Australian Securities and Investment Commission (ASIC), the UK Financial Conduct Authority (FCA) as well as the Cyprus Securities & Exchange Commission (CySEC).
Clients are able to open a live account and also practice for free in demo mode. The platform offers flexible solutions for all CFD traders – keeping in mind that trading CFDs can be high risk and is not suitable for everyone.
This article was developed in collaboration with Capital.com, a Stockhead advertiser at the time of publishing.
This article does not constitute financial product advice. You should consider obtaining independent advice before making any financial decisions.