CFDs can seem like a complex topic. Yet, they dominate online trading for most financial assets ranging from forex to crypto. Thanks to the versatility of CFDs, traders don’t have to hold physical currencies or real gold to speculate in either market. Let’s learn about this concept in more detail here.

What Is A CFD?

What Is A CFD

CFD stands for ‘contract for difference,’ an agreement between a trader and a broker to exchange the difference between a market’s opening and closing prices. CFD trading brokers compensate the trader in profit or debit their account depending on the outcomes of their positions.

Let’s consider a simple example with EUR/USD or the ‘euro’ trading for 1.10000. Assume that a trader believed that this forex pair would fall by 100 pips to 1.09000 (where every pip equals $10). They have also set their maximum loss amount at 50 pips at 1.10500 price.

A CFD, in this example, presents two outcomes. The broker would credit the trader’s account $1000 ($10 X 100) if the euro fell to 1.09000. Or, they would deduct $500 ($10 X 50) if it went to 1.10500.

One massive benefit of a CFD is that no physical exchange of the traded asset happens, nor does the trader need to own the underlying asset. They can speculate and profit from the price of gold without keeping the actual precious metals. Alternatively, they can gain from the fluctuations of foreign currencies without owning these in their bank accounts. The same logic applies to other securities.

We commonly refer to CFDs as derivatives as their prices are derived from real markets despite not exchanging tangible assets.

  • Leverage: Leverage is another attractive (but volatile) element of CFDs. It’s a gearing mechanism where one can trade a more prominent position with a relatively small account or margin.

The purpose of leveraged trading is to be able to allocate far less capital than a traditional investment in the traded asset. However, leverage amplifies gains and losses equally.

  • Long/Short Duality: CFDs allow speculators to buy and sell a particular market quickly and easily. Often, these two actions can occur at the same time, provided they have enough margin. It’s easier to sell most traditional investments by owning them first.
  • Over-the-Counter Trading: CFDs are traded ‘over the counter‘ (OTC), which refers to trading between private dealers or brokers rather than a central exchange. OTC participants have less strict requirements, meaning they can provide more experimental features like exotic markets and increasingly higher leverage.

CFDs Vs. Investing

Most trading nowadays is classified as a CFD or investing. Although CFD traders are technically investors, they don’t conform to the standards of a typical investment. The first difference is in the time horizon.

While CFD trading favors short-term speculators, traditional investing involves long-term capital allocation or buy-and-hold. The following distinction is that investors must take full ownership of the assets they invest in (in contrast with CFDs). So, a gold or silver investor owns these precious metals in tangible form; a stock investor owns stocks from a proper exchange; a crypto investor owns the actual digital currencies.

Thirdly, investors must commit the total value of the investment, whereas this isn’t the case with CFDs due to leverage.

Finally, conventional investing makes it hard to ‘short’ an asset without buying it first. Meanwhile, CFD traders can sell in any market even if they didn’t ‘go long’ or buy initially.

The Different Types Of CFDs

Different Types Of CFDs

Let’s briefly look at the most popular CFDs:

  • Forex: These are CFDs for the trading of prices for foreign currencies, e.g., EUR/USD, USD/JPY.
  • Cryptocurrencies: These CFDs allow traders to buy and sell the prices of digital currencies like Bitcoin and Ethereum paired against each other or standard forex currencies.
  • Stocks: A stock CFD is derived from the prices of shares or equities listed on many stock exchanges globally.
  • Indices: The trading of these CFDs primarily involves stock indices like the S&P 500, DAX 40, and FTSE 100.
  • Commodities: These are CFDs based on trading several commodities like precious metals, crude oil, and natural gas.

Advantages Of CFDs

So, why do CFDs continue gaining popularity?

  • Leverage: This feature allows traders to make huge profits in a shorter period than long-term investing. Leverage also offers a lower capital barrier where speculators can begin trading often with a few dollars.
  • No Physical Ownership: Owning certain assets in their real or physical form is complex and cumbersome. Meanwhile, CFDs eliminate this requirement while providing complete exposure to the traded asset.
  • Going Long and Short: CFDs permit traders to have bullish and bearish outlooks and take positions quickly for either bias. As explained before, this isn’t possible with conventional investing.
  • Diversification: Brokers let their clients trade several CFDs under one platform, making it convenient to diversify.

Disadvantages Of CFDs

Of course, CFDs have some notable downsides.

  • Potential for Financial Loss: It’s a clichéd but true phrase that leverage is a double-edged sword. When used irresponsibly, it can amplify one’s losses rapidly.
  • Counterparty Risk: Earlier, we mentioned that CFDs are traded over the counter. Generally, there needs to be more transparency with this method. Although CFDs are contractual, there is always a guarantee the broker can fulfill their objective of settling the difference due to internal issues or simply needing to be regulated.
  • Lack of Regulation: This point extends from the last one. OTC trading is relatively unregulated due to its decentralized nature. Thus, it’s common for traders to lose their funds or have issues withdrawing profits.

Little To Stop The Prominence Of CFDs

CFDs are simply trading a replica of a financial asset with the privilege of profiting from its price movements using a computer and internet connection. Modern technology has made this possible, resulting in a trading boom that anyone globally can access. However, CFDs do have considerable downsides, given that they are speculative and based on the short term. That’s where proper investing becomes attractive and tends to be more regulated. Thankfully, traders can participate in both CFDs and investing for diversification purposes.