A Contract for Difference, commonly referred to as a CFD, is a relatively new member of the investment community. A CFD is a derivative investment. It is linked to an underlying asset,which can be a share, an index, a commodity or a forex pair, but does not involve a direct investment in the underlying.
CFDs enable individuals to gain leveraged exposure, to investments including stocks, commodities, and currencies. The use of leverage creates a substantial increase in financial risk, and for this reason, CFDs are only suitable for sophisticated investors with very high risk tolerance levels.
Through CFDs, investors have convenient access to markets which may not otherwise be available to them. A CFD can be opened as either a long position, or a short position. Those who believe the price of the underlying asset will go up, will open a long position, while those who believe it will fall, will open a short position. Essentially, going long means you are buying the asset, and going short means you are selling it.
A CFD is 'closed' by taking the opposite action to the opening trade. If a long contract in Gold is opened by buying Gold, it is closed by placing a matching sell. Conversely a short contract in Gold is opened by a sell order, and closed by matching buy order.
Profits and losses on CFDs are determined by the change in the price of the underlying asset. If for example, we open a long position on Gold at $1289, then close it when the price reaches $1,300, the profit is $11. If we had opened a short position on Gold at $1,289, and the price was $1,300, then we'd incur a loss of $11
While a gain or loss of $11 or 0.85%% may not seem all that exciting, but the returns available on CFDs increases substantially, when we consider the leverage factor. For example, one CFD provider, Plus500, allows a leverage ratio of 1:152 on Gold. This means that to gain exposure to a contract with an opening value of $1,289, an investor only needs to put down an initial deposit of $8.52 or 0.66% of the total amount invested.
Now if we look at a gain or loss of $11, the returns to the investor (based on the amount they invested has become a gain or loss of 129.11%. The returns to the investor have been magnified by the leverage by the same ratio. So for every 1% move in the price of the underlying asset, there investor will incur a change of 152% to their investment.
This leveraged effect, and the fact that CFDs can be opened as either short or long positions, is part of why Contracts for Difference have become very popular with speculative traders. It allows them to generate significant returns from a small initial outlay.
There are several CFD providers on the market. The example above refers to the leverage available through Plus500. If you are considering trading with CFDs, then consider a free demo account with Plus500. There is no time limit on the demo account, and it allows you full access to the system so that you can truly test your strategy before putting any real money at risk.
We have used Plus500 both in demo and real money mode. We have used the web access as well as the mobile apps for both Android and iPhone.