The term trading sometimes has a different meaning compared to the term investing. Market pundits generally view trading as a process where a trader generates multiple transactions over a specific period.
This definition corresponds to the term investing, where the reference is that a trader is taking a few positions over a period. The upshot is that both traders and investors are looking for profits in the capital markets. What is clear is that different types of securities can be used to take a view.
Investors and traders will trade securities such as commodities, stocks, indices, cryptocurrencies, and forex. To access all of these securities, they need to trade these products directly or use contracts for differences (CFDs) that track the underlying product. There are many advantages to using contracts for differences.
CFD trading provides you with leverage using a margin account. It allows you to trade all of the products you are interested in trading in one account. CFD trading allows you to enhance your gains from small moves and buy and sell short every security your CFD broker tracks.
The available strategies include direction and relative value trades, which might not be as direct if you use a non-CFD trading account. CFD trading also comes with inherent risk, but we’ll get more into that later.
What is CFD Trading?
A contract for difference (CFD) is a contract between two counterparts. The contract tracks the movement of an underlying security, and the payout is the difference between the purchase price and the sale price. What is CFD trading can be answered by saying that it provides an investor with a way to take advantage of the price movements of an underlying product without owning the underlying product.
If you want to trade CFDs you need to use a CFD broker. A CFD broker provides clients with a bid and an offer for where they will purchase and sell CFDs that track different assets. The CFD value does not equal the underlying value of the security. The CFD only provides you with the differences in the value from where you purchase the CFD and sell the CFD.
For example, when buying a crude oil CFD, you are not buying oil at $100 per barrel. Instead, you are purchasing a security that tracks the movements of crude oil prices. The CFD value could be any number, but it is essential to track crude oil movements.
What Does CFD Trading Involve?
To get involved in CFD trading, you need to use a CFD broker. A CFD broker is a company that provides access to CFDs. Some CFD brokers are regulated, and some are not. A CFD broker will ask you for several pieces of information before they allow you to open an account and allow you to trade.
Some of the information they collect will be used to determine if they should allow you to open a margin account. A margin account essentially allows you to borrow capital against your securities. The margin account also allows you to use leverage to trade the market, which is an essential difference between CFD trading and other types of trading. Leverage allows you to enhance your gains, but it cuts both ways and can also accentuate your losses.
Your CFD broker will provide products that track underlying assets and allow you to use leverage. The leverage can be as high as 400:1 on some products. Four hundred to one leverage means that you only need to post $0.25 for something that has a value of $100. Your CFD broker uses a mathematical process that tells them how much equity you need to have in your account at all times to cover any losses.
They will not take losses for you. Suppose the value of your account comes within a range of you experiencing negative equity in your account (your losses are more significant than your equity). In that case, you will receive a margin call. If you don’t immediately add more capital to your account, your CFD broker will have the right to liquidate your positions. Make sure you read the fine print and understand how this can occur.
What is the Difference between CFD trading and Investing?
There are several benefits to CFD trading, including leverage. Leverage will enhance both your profits and your losses. In the example of 400 to one leverage, if you made $10 an asset that cost $100, you would make 10%. Using 400 to one leverage, you would make 4,000% ($10 / $0.25). Keep in mind that this same logic also applies to losses.
CFD trading also allows you to trade multiple assets in one place. You can trade the price of shares, commodities, indices, cryptocurrencies, and forex in one account. You don’t need to open several accounts to have this privilege.
CFD trading allows you to use relative value trades. You can purchase a commodity and simultaneously sell a stock. In this case, you are looking for commodity returns to outperform the stock price returns. When you trade other methods, this process is arduous and could be impossible.
CFD trading also uses margin netting, which is impossible if you have multiple accounts. If you have gained in one CFD, they can offset the losses in another CFD. You can also use different amounts of leverage when you trade CFDs. Most CFD brokers use different amounts of leverage based on the volatility of each product and regional regulations.
Investing is a long-term approach to trading. Generally, investing entails buying and holding a security for an extended period. Many investors take a relative value approach, looking for undervalued assets. CFD trading is usually a short-term approach to investing.
The Bottom Line
The upshot is that CFD trading is different from investing. One of the most apparent benefits is that you never have to own the underlying security. When you purchase a CFD, you buy a contract that provides you with the difference in the purchase price and the eventual sales price. CFDs offer you leverage via a margin account.
The leverage can be as high as 400, significantly enhancing your returns. Remember, leverage cuts both ways and can make trade riskier. CFDs allow you to net your margin. They will also allow you to trade long and short positions in different assets, which can be difficult if you are trading using multiple non-CFD accounts.