What Is CFD Trading?
Contracts for Difference, or CFDs
Here we are going to take a look at Contracts for Difference (CFD); their history, what they are and what CFD trading entails, looking at the advantages for the individual trader or investor.
For the retail trader or individual market participant, the trading and investing world have expanded in the 21st Century to offer opportunities that were unthinkable in the latter 20th Century. These advances have been aided by technology improvements, the openness of financial markets and the better education of the trading and investing population. As well as the development of markets in CFDs.
Advantages of CFD Trading
There are three key advantages for trading using CFDs:
- 1. The ability to have short and long exposure
- 2. The capacity to trade with leverage, on margin
- 3. The ability to hedge
CFDs: A brief history
CFDs were developed in the 1970s in London and were originally designed for institutional investors. They were intended to allow investment and hedge funds to leverage their market exposure (we will discuss leverage below) and also to hedge their positions (again, hedging is examined later).
In the late 1990s, though, CFDs started to be used by retail brokers to allow individual traders and investors to trade and invest in numerous asset classes. This enabled individuals to trade numerous markets and assets, to “go short” of these assets, whereas before, it was only really feasible to buy and own assets (to “be long”).
Furthermore, retail brokers offered trading on margin to retail investors, allowing capital and funds to be leveraged.
1. Short and long exposure
The easiest way to comprehend the idea of margin and leverage is to look at an example. Let’s look at the price of Gold and see how leverage work when trading or investing in CFDs. If you thought the price of Gold was going to go up, you could either buy physical gold or buy the Gold CFD (where you would NOT actual own any Gold).
2. Leverage/ Margin
The easiest way to comprehend the idea of margin and leverage is to look at an example. Let’s look at the price of Gold and see how leverage work when trading or investing in CFDs. If you thought the price of Gold was going to go up, you could either buy physical Gold or buy the Gold CFD (where you would NOT own any Gold).
If you had $10,000 in an unleveraged investment account and Gold was trading at $1,000/oz, then you could buy 10oz of Gold, which would use up the full $10,000 in your account. But if you used the same $10,000 to buy a Gold CFD, that is traded on margin (with leverage), you would not need as much in your account, to buy the equivalent 10oz.
For example, if the leverage was 5 times, this means you would only need 20% of the value in your account. So, you would need just $2,000 to buy 1 oz of Gold. So, with a $10,000 CFD account, it would be possible to buy 50 oz of Gold in terms of CFDs. So, the leverage for the CFD account is 5 times the normal unleveraged investment account.
This concept of leverage means that if Gold doubled in price from $1,000/oz to $2,000/oz and you invested via an unleveraged investment account, you would profit in this unleveraged account with a 100% profit of $10,000.
For the CFD account, however, you could have bought 5 times the amount of Gold, so on the move up from $1,000/oz to $2,000/oz, you would return a 500%, so $50,000 profit. This is an advantage of trading with leverage or on margin.
Please do remember though: if the Gold price had fallen by 20% to $800/oz, in an unleveraged account, the value of the account would fall from $10,000 to $8,000. For the same trade with a CFD account on 5 times leverage, the account would have been wiped out, a 100% loss, $10,000 lost. Trading CFDs on margin with leverage means potentially bigger rewards, but this comes with possibly more significant losses.