What are CFDs and how do they work?

CFDs are investment tools that can concern any instruments. CFD stands for Contracts For Difference, i.e. contracts for exchange rate differences to be more exact. How do they work?

CFD Structure

Contracts for difference are unlisted derivatives, i.e. derivative instruments that are not listed on exchanges. You can use them to invest in the following:

  • shares,
  • currencies,
  • raw materials,
  • stock market indexes.

If the investor chooses a currency CFD, they do not directly buy euros or dollars but an instrument that reflects the prices of the underlying instrument. The contract for difference (more info) might be described as a contract concluded between the parties – the investor and a CFD broker – for the exchange of the difference that occurred between the opening and the closing price of a given position.

Long and short position

In the case of CFDs, investors can make money not only on increases, but also on decreases in the value of a given asset as the investor anticipates that the price of a given asset changes towards a given direction. If the investor anticipates that the price of a given asset increases, the investor opens a long position, which involves buying given assets. In turn, if they anticipate a decrease in prices, they open a short position – in other words, the investor sells given assets. The duration of CFD transactions is measured from the time the position is opened until a reverse transaction is played. When the investor opens a long position, it will end upon opening of a short position in relation to the same asset.

Important financial leverage

In the case of CFD transactions, the mechanism of leverage, i.e. financial leverage, is used. It allows opening a position of the value much higher than the value of the capital available to the investor (more info about FX and CFD market). In practice, the investor has only a part of the transaction amount, in the form of initial margin, but may dispose of and freely trade in the full value of the asset. If the investor anticipates change in the price of assets under CFDs well, their yield will be dozens of times higher than the actual investment. However, bad decisions entail magnified losses. Therefore, the investor must pay the difference between the actual loss and the value of the initial margin.

Spreads in CFDs

What is important in CFDs is the spread, i.e. the difference between the buying and selling price. In other words, it is a buying and selling price bracket or a difference between the current price at which the investor can buy and sell given assets. The rule is that the buying price is higher than the selling price and the price of the underlying instrument, which is the basis of a CFD, is somewhere between those two values.

Spread is the key cost of CFD transactions incurred by the investor. The narrower the spread is, the better result may be yielded on a transaction.

Forward contracts and CFDs

Two terms have to differentiated here – CFDs developed on the English stock exchange twenty-five years ago and forward contracts. They have some common features, but contracts for difference – CFD – do not have a specified ending date – position closure, they are flexible and more attractive to investors, thanks to every-day renewal and real-time settlement. They are exempt from stamp duty and allow comfortable investing with many different underlying instruments, also uncommon ones like crops or coffee.

CFDs consist in the investor paying funds to secure the opened transaction. They deposit an initial margin. Its level depends on the value of the transaction, individual requirements of brokerage firms and, to some extent, investment purposes, which are in turn connected with the financial leverage that can be applied.

Check also: https://www.youtube.com/channel/UC-mfgGnt3tXtkDnFpl02f2Q

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