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CFDs (contracts for difference) trading allows investors the ability to go long or short and the opportunity to make money in a falling market without the need to put up large amounts of capital, making them a more flexible way of investing. CFD trading is often used for speculative purposes. CFDs can be used to speculate on the future movement of market prices whether the price of the underlying product is rising or falling.
CFDs are leveraged products that allow you to trade while only paying a fraction of the total value of the contract. When you trade a leveraged product, you can potentially magnify your return on investment. But with great potential returns also comes greater risk. The higher leverage can result in losses that could exceed your initial deposit.
Investors can use CFDs to gain instant exposure to major global markets including the UK, US, Europe and Asia. See our range of CFD trading markets.
Gains from CFDs are eligible for Capital Gains Tax as unlike Spread Betting it is not regarded as gambling. However any losses incurred through the trading of CFDs become tax deductible.
CFDs are generally offered for margin trading, which means that traders are only required to deposit a portion of the actual trade size in each transaction. For example, if you have a CFD trade worth £1,000 (either in a short or long position) and your provider’s margin requirement is 4%, this would mean you only need £40 to open the position.
It is generally recommended that less experienced traders use smaller lot sizes until they have developed a successful trading strategy that is more consistently profitable. More experienced traders can choose to put more capital at risk so that they do not feel limited in the way their trades are structured.
One method that traders use to limit potential risk during market volatility is the implementation of ‘hedged’ positions. For example, if you have a long position on a CFD that is accruing losses, you can open a position in the opposite position using a short CFD.
Contracts for difference (CFDs) are one of the world’s fastest-growing trading instruments. A contract for difference creates, as its name suggests, a contract between two parties speculating on the movement of an asset price. The term ‘CFD’ which stands for ‘contract for difference’ consists of an agreement (contract) to exchange the difference in value of a particular currency, commodity share or index between the time at which a contract is opened and the time at which it is closed. The contract payout will amount to the difference in the price of the asset between the time the contract is opened and the time it is closed. If the asset rises in price, the buyer receives cash from the seller, and vice versa. There is no restriction on the entry or exit price of a CFD, no time limit is placed on when this exchange happens and no restriction is placed on buying first or selling first.
A CFD allows a trader to gain access to the movement in the share price by putting down a small amount of cash known as a margin. Trades are conducted on a leveraged basis with margins typically ranging from 1% to 80% of the underlying value of the financial instrument. For indices or currencies, these margin requirements can be as low as 1 percent of the underlying value of the security.
When you enter a CFD contract you are not buying the underlying share, even though the movement of the CFD is directly linked to the share price. In fact, CFDs mirror the movement and pricing of the underlying share. However, since you do not own the share, you are only required to provide a deposit to your CFD provider which could be as low as 5% for blue chip shares. This means you can trade up to 20 times your initial capital and it thus possible to create significant profit through ‘margin’ as you only have to use a deposit to hold a position, meaning only a small proportion of the total value of a position is needed to trade allowing the client to magnify market exposure. For instance, with a stock CFD that requires a 5 per cent margin to open a trade, a 5 per cent increase in the market price of the underlying stock results in a stunning 100 per cent return on the investor’s capital. However, this cuts both ways and there need only be a 5 per cent fall in the market price of the share to result in a 100 per cent loss for the investor.
CFDs do not have an expiry date like options or futures contracts. As opposed to an expiry date a CFD is effectively renewed at the close of each trading day and rolled forward if desired – you can keep your position open indefinitely, providing there is enough margin in your account to support the position. In this stance contracts for differences are very similar to futures without an expiration date. While the contract remains open, your account with the provider will be debited or credited to reflect interest and dividend adjustments.
One of the great features of CFDs is that you are able to trade on both the long and the short side of the market i.e. you can choose to ‘long’ or ‘short’ a position – if you are long, you receive dividends and pay interest, if you are short you do the reverse. It is worth noting that commission is paid on either side of the contract and you can close a contract at any time.
Trading the long side in practice means that you have used a buy instruction as your opening CFD trade or ‘gone long’. For trading shares ‘going long’ refers to opening a buy CFD position to profit from a share price increase. This implies that you are expecting a rise in the asset’s price and will use a sell order to close your position. Trading the short side means that you have opened your CFD trade using a sell order or ‘gone short’.
‘Going short’ refers to opening a sell CFD position to profit from a share price decrease. This means that you are anticipating stock prices to fall and will use a buy order to close your position (although this may sound a bit strange it is really another way you close out your position in the market). The benefit of short trading is that you can profit directly from falling asset prices, which is difficult to do without the use of products such as contracts for differences.
Leverage allows a client to trade a specific market without being required to deposit the full contract value, whilst having the same underlying risk.
Another way to refer to margin requirement is the leverage offered by a broker. A 2% margin requirement is equivalent to offering 50:1 leverage while a 1% margin requirement can also be referred to as 100:1 leverage.
A hedge is a trade to reduce the risk of adverse price movements on an existing position. Normally, a hedge consists of taking an offsetting position in a related security.
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Forex and CFDs are leveraged products which can result in losses greater than your initial deposit. Therefore you should only speculate with money that you can afford to lose.
Please ensure you fully understand the risks involved, seeking independent advice if necessary prior to entering into such transactions. Please click here to view our Risk Disclosure..