What is a CFD trade?
In finance, a contract for difference, or CFD, is a type of financial derivative that allows traders to profit from movements in asset prices. Speculations on prices moving up are known as long positions, and bets of prices moving down are known as short positions.
A CFD is an arrangement made in a futures contract whereby differences in asset price are settled through cash payments, rather than by the delivery of physical goods or securities. This is generally an easier method of settlement, because both losses and gains are paid in cash. CFDs provide investors with the all the benefits and risks of owning a security without actually owning it.
Advantages of a contract for difference
The main advantage of a CFD is that it provides higher leverage than traditional trading. The lower the margin requirements, the less capital outlay and greater potential returns for the trader. This characteristic makes CFDs very appealing to speculators.
In addition to that, the CFD market is not bound by minimum amounts of capital or limited numbers of trades for day trading. Besides, because CFDs mirror corporate actions taking place, a CFD owner receives cash dividends and participates in stock splits, increasing the trader’s return on investment.
There are not many rules regarding the short-selling of CFDs, allowing plenty of flexibility for short-sellers to speculate. Since there is no ownership of the underlying asset, there is no borrowing or shorting cost. In addition, few or no fees are charged for trading a CFD.
Disadvantages of a contract for difference
Due to the daily costs of holding a long position, CFDs are not suitable for a buy-and-hold strategy or long-term positions.
Paying the spread on entries and exits restricts profits on small movements in price, and reduces the gains from winning trades – losses are also increased.
Category: Financial Glossary