CFD 101: All You Need to Know to Get Started

“An investment in knowledge pays the best interest.” – Benjamin Franklin

The world of online financial market trading can be an overwhelming, intimidating place for a regular person. However, it doesn’t need to be. As the quotation by Benjamin Franklin states, knowledge is the best way to overcome the fear of the online financial market trading industry.

Therefore, let’s start by looking at the definition of CFDs and then we will look at how to utilise them effectively to manage our portfolio.

CFDs: Associated Terms

In order to understand what a CFD is, we need to take a look at the following terminology:

Derivatives and futures contracts

A futures contract is a derivative. In other words, its value is based on the performance of the underlying asset.  This performance is measured by looking at the price movements of the asset.

It is also important to note that a futures contract is a legally-binding agreement between broker and client (or seller and buyer) to buy or sell a financial instrument or stock at a predetermined price and time in the future.

Margin

Buying on Margin means that the client borrows money from the broker to purchase an asset. This trading strategy is used as a short-term trading strategy as the costs of borrowing money in the medium- to long-term are prohibitive and do not make sound financial sense.

Leverage

Leverage is another trading strategy which uses borrowed money to increase the potential return of an investment. It is very similar to Margin; however, leverage is the act of borrowing money, while Margin is the debt itself. CFDs or futures contracts are a typical example of adding leverage to an investment portfolio.

Short-selling

Short-selling is the process of investing in an asset when the stock price is expected to drop. For instance, if the share price of an asset is x-value, and it is anticipated that its price will drop shortly, it is possible to take advantage of the situation, by borrowing 100 shares at x-value from a broker to sell in the future at x-value minus the value that the price has dropped.

Long-selling

The term “long-selling” is a strategy that is exactly the opposite of short-selling. However, it is not traditionally used as a short-term trading strategy. It is most effective as a long-term trading strategy.

CFDs: A concise Definition

Simply stated, a Contract for Difference (CFD) is a futures contract where the value of the contract is based on the performance of the linked underlying asset. Primarily, CFD traders trade on Margin; a small percentage of the contract’s total cost is deposited to open a trading position. Additionally, in order to make the correct trading decisions when determining whether to trade short or long, it is vital for CFD traders to access accurate live share prices.

Final words

The importance of sufficient knowledge should not be underestimated when trading CFDs. Essentially, not taking the time to understand the intricacies of how to trade on the global financial markets before placing live trades can lead to devastating consequences.

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