CFD stands for contract for difference. A CFD is a financial instrument that allows traders to bet on share price movements without actually owning the underlying asset. It’s one of the most popular forms of trading globally.
Understanding CFDs to minimise risk to your bankroll
When you buy or sell an ordinary share, it is registered in your name with the relevant company and its stockbroker. With a CFD, no physical share certificate is issued – all that changes hands is an agreement between two parties to exchange the difference in value between when they entered into the contract and when they exited from it.
Thus CFDs are bought and sold ‘over-the-counter‘, meaning there is no central record of who holds what position at any given time. As a result, using CFDs can be more tax-efficient than trading in ordinary shares or other securities because capital gains are only made when the contract is closed.
If you sell your position early, you don’t have to pay anything on the profits. CFDs also allow traders to speculate on the price movement of an underlying asset without taking physical delivery of that asset.
The risks of CFD trading
This type of trading has been around since 1964, and it’s a good way for people with a high level of knowledge about a particular market or commodity to make money from their insights.
However, because there is no actual asset involved, this form of trading carries significant risks. If you trade large volumes, then you could end up losing much more than your initial investment. It is because when you buy an ordinary share, for example, there’s a market price that you have to pay for it. The stockbroker then issues a certificate showing that you own the shares, representing a ‘claim’ on the company’s assets.
So if a company issued 1 million shares at £1 each, and they were all bought by investors who paid in full before any trading began, then once trading started at £1 per share, nobody could sell them for more than £1 until they had sold them again to someone willing to pay more than £1. In other words, there would never be any point during which anyone could get out of the asset class without losing money.
However, with CFDs, it’s possible to close your position at any time, so if you need to sell your holdings quickly, then the market price is unlikely to be favourable for you.
The benefits of CFD trading
The above may seem like a disadvantage, but it can also be an advantage. Many traders use CFDs to take advantage of temporarily mispriced share prices or currency values lagging behind world events.
For example, suppose that Company XYZ announces good news about their upcoming product launch and their shares go up immediately on the news, while other stocks in the same industry fail to react. If you’re long XYZ shares via a CFD, then this will make money for you without risk – since there are no underlying assets involved, it doesn’t matter whether or not other people can identify the opportunity too.
Once the market has caught up with reality, then you can close your position before anyone else realises what’s happened, at which point it will be time to find a new mispriced asset.
CFDs are also helpful for black swan events that result in large share-price movements – if another part of the world suffers an earthquake or some other natural disaster, for example, this may have implications for companies selling products there. By overseeing news sources, professional traders can use these situations to take advantage of misplaced market reactions.
Even though CFDs are not suitable for long-term holders, they have their uses as speculative tools. Many serious investors also trade via CFD contracts because they allow them to buy and sell quickly without paying commission or dealing with complicated paperwork.
CFDs are also frequently used by professional traders who specialise in the market making where speed is of the essence. If you want to put some money into trading – whether it’s for short-term gains or as a sideline to your main occupation – becoming familiar with CFD contracts could help you achieve your goals more effectively than simply buying shares and hoping for better returns.