CFDs are very popular trading instruments which offer the benefits of flexibility, global access and the potential to enjoy handsome profits. In essence, a contract for difference is an agreement between the buyer (investor) and the seller (broker). The investor predicts that the value of an underlying asset will move in a specific direction during a specific period of time. However, he or she never actually holds this asset; their position is only mirrored by the CFD. Should this prediction prove to be true, the CFD is liquidated and the funds are then distributed to the trader. However, the ability to leverage one’s funds is another critical component to appreciate. Let us take a look at how this process works before restating the benefits of a CFD trade.
Leveraging: The Basics
It is first a good idea to understand how a traditional financial leverage functions. Let us imagine that a trader wishes to purchase 10,000 shares of company ABC at a price of £5 pounds per share. The total amount leveraged (the final cost) would therefore be £50,000 pounds. While this is an extremely straightforward process, it should be noted that any profits will be related to the discrete movement of the share price. CFD leverages work a bit different.
A Look at a CFD Leverage
One of the main benefits cited by novices and professionals is that contracts for difference employ a different leveraging system. Although the level of exposure in regards to a certain position (such as a currency pair or a commodity) is the same as with a traditional trade, only a fraction of the full price needs to be paid. Let us take a look at an example to clarify this notion.
We will take the same 10,000 shares in company ABC which were mentioned previously. Their cost is still £5 pounds per share. However, a broker offers a margin rate of 20 per cent. This signifies that only 20 per cent of the total amount must be paid for up front in order to open the position. As opposed to depositing £50,000 pounds, only £10,000 pounds will be required. This is an obvious benefit for those who may not otherwise have access to a substantial amount of funds. Another term for this strategy is known as trading on margin.
Margin Trades: Risk Versus Reward
Now that we appreciate the mechanics behind a leveraged CFD trade, it is essential to note the benefits and risks that can be involved. The first major advantage is that a minimal amount of capital outlay is required. Thus, the trader is able to reap exponentially higher rewards with a position should it move in the predicted direction. Massive profits can be gained within an extremely short time frame.
The downside to this strategy is that a trader can likewise incur substantial losses within this very same period of time. While only a fraction of the total price needs to be leveraged (10 per cent in the aforementioned example), the individual is still exposed to the full price of the position. Losses can be dramatically magnified and one could very well pay more money back than was initially invested.
CMC Markets offers thousands of different CFD positions with ranges from 0.7 to 1 point. This is one of the reasons why CMC Markets is one of the most popular trading platforms currently available. As massive gains or losses can result from any leveraged trade, it is critical to understand how these instruments function as well as to invest with prudence in mind.