A contract for difference is a derivative security that tracks the changes in the price of an underlying asset. CFDs offer investors a platform to speculate on price movements without actually buying or selling the underlying asset. As a result, CFDs help investors better manage risk by diversifying their portfolios. For example, if an investor holds both an underlying asset and CFDs on that asset, the investor can apply CFDs to manage risk.
How CFDs Work
CFDs allow you to buy a fraction of a currency or a portion of a commodity to gain exposure to a market that would usually be beyond your reach. A CFD is like a futures contract, though it allows you to buy the share at a future date rather than sell it.
CFDs are effectively nothing more than bets on the future movement of a market. Thus, you can use them as a “stop-loss,” as a way of limiting losses when the market moves against you, or as a “risk-on” to gain market exposure.
Benefits of Trading CFDs
The most important benefit of trading CFDs is that it lets you trade on margin. As such, you can borrow money from your broker without having to pay for all of it upfront. This arrangement allows you to make much larger trades than would typically be possible with your available cash, which should lead to higher returns as long as the market moves in the right direction.
Trading CFDs provides flexibility as you can trade on various assets, including shares in companies and indices. This flexibility means that you should find an asset that you feel will move in your preferred direction in the foreseeable future.
You can long trade or short trade CFDs knowing that you will profit from whatever direction prices go. You can also use CFDs to hedge your current stock portfolio to minimize risk.
Risks of Trading CFDs
Liquidity is the risk of not being able to convert an asset into cash quickly enough to repay debt or cover expenses. It’s a type of market risk that arises due to the temporary illiquidity of investment, security, or commodity, leading to losses when trying to sell it at the current price.
Trading risk is the cost of assuming the price of a product changes before entering into your position. You can mitigate trading risk by conducting trades on a regulated market.
A Counterparty is a form of risk whereby the actions of one party may negate another party’s position. When counterparty risk is high for a CFD product, the price you pay or receive can vary significantly from that paid to or received by your counterparty.
Interest rate risk
The interest rates risk arises from changes in interest rates and may affect a fixed income portfolio because of exposure to duration and liquidity mismatch. An example is if an investor has fixed-income assets for five years and plans to spend the money in two or three years. Thus, any interest rate increase will affect that investor’s cash flow and could result in not having enough money for retirement.
Risk arising from the inability to meet margin calls, i.e., when your broker asks you to top up your deposit or close a position to cover losses. If you don’t have the money, you may have to liquidate other positions in your account.
Foreign Currency risk
Currency risk refers to the risk of loss when one currency is converted into another. The value of foreign exchange can change due to different variables that can affect the strength of a currency, including interest rates, inflation, trade balance, and political stability.
There is a potential for losses across all investment classes due to general market conditions or factors that affect all securities in an economy. However, you can diversify the market risk by holding a broad portfolio of different stocks, though you can never eliminate all the threats.
CFD contracts bear a high risk of losing money rapidly due to leverage. Therefore, it would be prudent to learn how CFDs work. Before deciding to trade, please ensure you fully appraise the risks involved and consider your level of experience.