CFD’s or contracts for difference are derivative products that are traded very similarly to options and futures for those of you who are familiar with those. The one main difference is that there is no contract dictating the end date of the trade. In other words, you can hold the trade as long as you want based on how the position is playing out. Let’s now explore a little more on the basics of these financial instruments and then look at an example trade to illustrate how they work.
What is a CFD?
A contract for difference is the difference between where a trade is entered and exited. This instrument will mirror the underlying assets price movements but you’ll never actually own the asset itself. It’s essentially a contract between a client and a broker. As with any investment, CFD’s come with advantages and disadvantages which we will go into later.
How a CFD Works
CFD’s give you the ability to use more leverage than with traditional margin trading. While a margin account with a traditional broker will require you to set aside at least 50% of the trade’s value, a contract for difference only requires you to set aside 5%. Just like with stocks, you can enter both long and short positions with CFD’s. As the value of the underlying stock or other asset increases or decreases, your CFD’s value will also follow suit.
CFD’s require less capital reserve and you can find the margin requirement for such accounts to fluctuate between 2 and 20% percent. This ability allows you to make more money than with traditional margin trading. In addition, you can profit from stocks whose share price is too high for you to purchase with the funds you have; shares of Google or Berkshire Hathaway come to mind. You can actually buy interests in these great companies with only a few hundred dollars. In addition, many brokers make it easy to open an account with only $1,000 or $2,000 minimum deposits.