Contracts for Difference (CFDs) are financial derivatives that allow traders to speculate on the price movements of various assets without owning them. These assets can for instance be company stocks, commodities or currencies. They can also be other derivates.
In this article, we will take a look at few different types of CFD, based on which type of underlying asset they have.
For a trader, CFDs offer several advantages, including the ability to gain exposure to various asset classes without ownership. Since you are not actually buying, owning and selling assets, it is very easy to profit from both rising and falling markets without having to do risky short-selling with and unlimited downside.
Brokers that offer CFD trading pretty much always also offer leverage. In parts of the worlds, including the European Union, the authorities have capped how much leverage a broker is allowed to give to a non-professional trader (retail trader), and some countries also require Negative Account Balance Protection for non-professional traders. In countries where there is a cap, the cap will typically vary depending on the type of underlying asset.
Leverage can magnify both gains and losses, and because CFDs are often highly leveraged products, it is possible to lose more than your initial investment. Furthermore, since CFDs don’t provide ownership of the underlying asset, traders do not benefit from dividends in the case of stock CFDs, unless it is factored into the CFD price.
All in all, CFDs offer a flexible and accessible way to trade on a wide range of asset classes, including stocks, indices, commodities, forex, and even cryptocurrencies, but it is also risky, over-use of leverage can be tempting, and you never own any of the underlying assets.
The key to successfully trading CFDs is understanding the market you are engaging with and properly managing the risks associated with factors such as leverage and market volatility. Whether you are interested in the stock market, foreign exchange, commodities, or something else, CFDs offer a way to trade with minimal capital outlay while providing the opportunity for significant returns.
One of the most common types of CFDs is Equity CFDs, which are based on the price movements of individual company stocks.
When trading a CFD based on company shares, you do not own the shares but instead speculate on whether the stock’s price will rise or fall. Equity CFDs allow investors to engage in both long (buy) and short (sell) positions, depending on their market predictions.
One reason why CFD trading has become so popular among those who wish to speculate on the stock market is that they make it easy to speculate on company shares even if you have a small trading budget. At the time of writing, actually purchasing 100 shares in Apple (NASDAQ: AAPL) would cost $236 x 100 shares = $2,360. This can be quite a lot of money for a small-scale hobby trader that is just starting out, especially if they also want to carry out proper diversification and other types of risk management (which they should!) instead of putting a large chunk of their bankroll on shares in a single company. With a CFD, you decide how much money from your bankroll to put at risk, which makes it much easier to stick to a proper risk management strategies.
It should also be noted that there are some high priced publicly traded company shares that are out of reach even for retail traders with a mid-sized budget and where derivates such as CFDs come in very handy for speculation. The most notable example is Berkshire Hathaway Inc, as a single Berkshire Hathaway Inc Class A (NYSE:BRK.A) would cost you $698,000. Considerably cheaper, but still very pricey, are NYSE:NVR which is currently trading at $9,655, NASDAQ: BKNG which is at $4,363, and AMEX:SEB at 2,993.
Index CFDs are based on an index, such as a stock market index. Examples of indices that are very popular for speculation worldwide are S&P 500, FTSE 100, and DAX 30. Rather than focusing on individual stocks, a stock index CFD allows you to trade on the movements of a basket of stocks. This approach can diversify risk because the index represents a collection of stocks, often making it less volatile than individual stocks. Index CFDs are an attractive option for those who want to speculate on broader market trends rather than specific companies.
For those interested in speculating on commodities, Commodity CFDs provide access to markets like gold, oil, natural gas, and agricultural products. These CFDs allow traders to benefit from price changes in commodities without needing to handle the physical product. Commodities are often seen as a hedge against inflation, and CFDs on commodities allow for speculative trading on both rising and falling prices.
Examples of commodities that are popular among CFD traders:
Forex CFDs (Currency CFDs) allow traders to engage in the foreign exchange market by speculating on currency pairs like EUR/USD or GBP/JPY. The forex market is the most liquid market in the world, and forex CFDs offer the advantage of trading currency pairs with leverage. This is appealing to traders who want exposure to currency price movements without actually buying, owning and selling currency.
With the growing popularity of digital currencies, Cryptocurrency CFDs have become a way for traders to speculate on the price of assets like Bitcoin, Ethereum, and others. Cryptocurrency markets are highly volatile, and using CFDs allows traders to benefit from this volatility without owning the actual digital currency. Unlike owning cryptocurrency, cryptocurrency CFDs provide a simpler, more accessible way to enter this market.
With the latest scandals and hacks surrounding certain cryptocurrency exchanges, many traders appriciate how CFDs makes it possible for them to speculate on cryptocurrency exchange rates without actually having to put any money into a cryptocurrency exchange/trading platform online. They can use their standard CFD broker to gain exposure instead.
Bond CFDs allow you to trade on the price movements of government and corporate bonds. These instruments are less volatile than stocks or commodities, making them attractive to more risk-averse investors. Popular bonds available for CFD trading include US Treasury Bonds and German Bunds. Bond CFDs are often used as a hedge during times of stock market volatility.
ETF CFDs allow you to speculate on the performance of exchange-traded funds (ETFs).
An exchange-traded fund (ETF) is an investment fund that is also an exchange-traded product. Its shares are bought and sold on a stock exchange, e.g. on NYSE. Just like other investment funds, the ETF can own a variety of assets, such as stocks, bonds, debts, and commodities.
