Contract For Difference (CFD)

Contract For Difference (CFD)

Contracts for difference (CFDs) are cash-settled financial contracts that allow you to trade without owning the underlying asset. Find out how they work.
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Beginner
4 min read
Written by: Harry Atkins
November 30, 2019
Updated: February 24, 2021

Trading stocks as a contract for difference (CFD) is a popular way of gaining exposure to the broader stock market. CFDs differ from the traditional way of buying stocks and rose to prominence in the UK through the increase in CFD brokers. A CFD is a financial derivative that allows investors to speculate on the prices of underlying assets. With CFDs, you can speculate on the prices of stocks, commodities, stock indexes, and other securities.

Stock CFDs, which are some of the most frequently traded financial derivatives, allow traders to speculate on the prices of stocks without owning the underlying asset. They differ from company in that you do not own the shares outright.

A CFD allows traders to enter into an agreement and trade financial instruments based on price fluctuations. In the stock market, CFDs allow traders to leverage their trading by only having to invest a small margin deposit in owning a trading position, and speculate on price movements.

I. Key Traits of CFDs

  • With stock CFDs, you do not own actual shares of a company
  • Stock CFDs allow traders to enter long and short positions on any stock
  • Stock CFDs can be used as hedging tools
  • Stock CFDs attract overnight swap rates
  • There are no shareholder privileges with CFDs of stocks
  • You can trade CFDs using leverage to amplify profits

II. Stock CFD Trading Terms

Going Long

CFD stock trading is all about price speculation. Going long translates to a trader speculating that the price of a stock in question will increase upon buying. If correct and the price goes up, the trader would make a profit on the difference between the buying price and the closing price.

Going Short

Going short is the opposite of going long, where the trader speculates that a CFD stock is overvalued, and the price is destined to decrease. In this case, a trader opens a short position, which is essentially a sell. Should the price edge lower, the trader would be able to make a profit on the price difference between where he opened the sell position and the final price.

Margin and Leverage

In CFD stock trading, investors don’t need to deposit the full value of the stock they wish to buy. Stockbrokers offer what is often referred to as leverage, a device that amplifies the initial capital, allowing traders to buy stocks worth more than their invested capital.

For instance, if a stock is trading for $100, you would need $10,000 to own 100 shares. However, with CFDs, you would only need $200, assuming a leverage of 1:50.

The invested capital is referred to as margin. The benefit of using leverage in CFD stock trading is that it can amplify profits. However, being a double-edged sword, it also amplifies losses should a trade go against a trader.

III. Advantages of Trading Stock CFDs

Stock CFDs are some of the best for investors who do not have the full amount of capital needed to buy stocks of companies. The availability of heavy leverage makes it possible to enter trades where normal capital wouldn’t be sufficient.

The ability to enter both long and short positions allows investors to take advantage of prices going either up or down. Owning stock CFDs also entitles investors to perks, such as dividends.

Stock CFDs trade on fast-moving global financial markets, providing direct market access that accords traders an opportunity to trade them globally.

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