Contract For Differences Overview & Examples

CFD refers to a financial contract between brokers and traders to pay the price differences in the asset between opening and closing trade. Find out about what CFD is and how it works below.

What Is Contract For Differences (CFD)

First of all, a contract for difference (CFD) is a financial contract that enables traders to earn from the price fluctuations of a particular asset without actually owning the asset. It states the terms of the agreement between the broker and traders and that includes the asset being traded, the contract size and the price that was being agreed upon. The assets that typically use CFDs are forex, shares and commodities.

What Is Long And Short Trading In CFD

In the context of trading, “going long” or “taking a long position” normally refers to buying a particular asset as you are predicting that the asset will increase in value. On the other hand, “going short” or “taking a short position” are referred to as selling an asset with the expectation that it will drop in value. 

In a scenario whereby you have decided to go long on an asset and the asset’s price increases afterwards, you can choose to sell it and make a profit and you are earning based on the asset’s price when you are selling it. On the contrary, if you have decided to go short on an asset and if the asset’s price falls afterwards, you can choose to buy the asset back after its price has dropped and earn a profit. However, it is also crucial to be aware of the risks that CFD trading might give if the price of the assets do not move in the direction you are expecting. Hence, it is important to read up more on the topic of CFD trading and understand how you can trade CFD better. 

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What Is Leverage

Leveraging is called the act of borrowing capital, such as margin, to increase one’s potential return on trading financial instruments or an investment. In other words, it enables traders and investors to amplify the size of their trades so that they would have a chance to make larger profits. When traders decide to use leverage in trading CFDs, they are required to enter trade with a small amount of capital and the remaining amount required would be provided by the broker. Traders would then be able to use borrowed funds to trade on a larger scale, than what they could with the amount they could trade originally with their own capital.

What Is Margin

In leverage, the small amount of capital which traders are required for trading large amounts of assets is also called “margin”.

For instance, if a trader is interested in buying $20,000 worth of a particular asset, but only has $5,000 of their own capital, they can choose to use leverage, use $5,000 as the margin and borrow the remaining $15,000 from a broker to trade. An increase in the asset price would mean that the trader earns profit on both their own capital and the borrowed funds, and a drop in the price of the asset would mean the trader suffers losses on both their own capital and the funds they have borrowed as well. 

This type of trading carries a higher risk in return, even though it does not limit traders with small capital at hand from gaining high returns potentially. Hence, it is important for CFD traders executing this type of trading to have a good risk management strategy to back up any high losses that one may suffer from. 

What Is Hedging

Hedging is a risk management strategy that involves taking offsetting positions in financial instruments to reduce the risk of a financial loss. Hedging is widely used amongst traders to protect themselves against losses from trading an asset, by also trading or investing on another asset that might increase in value to offset the losses. 

If a trader or investor has a negative feeling about the price direction of an asset he or she is trading because of an event that is happening, he or she can choose and buy another financial instrument to hedge their risk. 

Even though hedging is a popular risk management strategy among traders and investors, one might not always be successful in mitigating their losses. It also comes with a certain level of risk and hence, it is key for traders to thoroughly understand the risks they might face before considering hedging as a strategy to help them in their trading journey.

Final Thoughts

Trading CFD may not be as simple as any other forms of trading. It is essential for traders or investors to gain a solid understanding of the risks it may carry. Beginner traders might want to find out more about the demo accounts PU Prime have to offer before jumping into trading with a live account.  

For traders who are interested, you can check out PU Prime’s trading platforms including our newly launched mobile app that also provides CFD trading below.

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