Pros and Cons of Trading CFDs
Certain trading terms such as contract for difference or CFD can intimidate new investors. But CFD trading is not a very complex concept for a simple mind to understand. It means that two parties agree on a contract to pay the price difference of the underlying asset. The asset in the contract can be a share, an index, commodity, cryptocurrency or fiat currency pair and it will be the foundation for the contract. A CFD will derive its value from the price fluctuations of the financial markets which is why it is known as a derivative.
In CFD trading there is an agreement between a broker and a trader, and they open a position to buy CFDs on the market. If the value of the asset rises, the trader will go long and earn a profit and if the value drops, they will go short and sell CFDs. However, if the prediction of the market movement goes wrong, the trader will have to bear the losses. In the transaction, the profit or loss will be the difference between the price of the asset at the start of the contract and the price at the end of the contract. Let’s take a look at the pros and cons of trading in CFDs.
With a CFD, you can enjoy high leverage, and this means you only need to deposit a small part of the total trade value. This is the initial margin and the exposure to the funds is then magnified so you can make more profit. If you use the traditional method of trading, your investment and exposure are the same. In CFDs it remains limited.
You can enjoy high flexibility with CFDs as compared to the traditional investment alternatives like shares or commodities. If the market is falling, it is the perfect trading opportunity with CFDs. The idea behind short selling is the prediction that the price of an asset will drop and will allow you to buy it back at a lower price in the future.
It is important to understand that leverage can be a pro and a con when it comes to CFDs. The key advantage can be the main drawback too. When you use leverage, it means a small amount of deposit will lead to high exposure but after you leverage the position, you could increase the potential of profit and losses. If the market goes in the opposite direction, the margin will dip below the agreed level, and you will have to deposit more funds. When you leverage, you are exposed to a high risk of losses.
Contract for difference is about speculating the changes in price and not about buying the underlying assets. Hence, you can own the contract but not the asset like share or commodity that the contract is based on. Owning shares in a company can give you dividend rights but with CFDs, you do not get any ownership.
CFDs are very popular and are used by traders to make the most of market volatility. They come with advantages and disadvantages that you must consider before you embark on CFD trading.
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