By Luis Aureliano

A CFD (Contract for Difference) is a derivatives trading instrument. Unlike traditional investments which require underlying assets to appreciate, CFDs allow for profits in bullish or bearish markets. However, there is much more to CFDs than meets the eye and this investment option warrants close analysis.

A CFD is unique in many ways. It is one of the most popular financial instruments in the UK and around Europe and it features prominently in investment portfolios. Conventional holdings of stocks, bonds, indices, commodities, currencies and the like work in a linear fashion. The asset needs to gain value over time for the investor or trader to benefit from it. With derivatives trading and CFDs, there is no purchase of the asset. A CFD can best be thought of as an investment that dovetails alongside the price movements of the asset in question.

An accurate CFD definition covers the key features of this trading instrument. Take a CFD on a stock for example. This would mirror the price movement of a specific stock and its price moves accordingly. Much the same is true of other investment options like Indices, Commodities, and Currencies. Instead of buying the asset and waiting for it to gain value, a CFD trader simply speculates on the CFD contract – bullish or bearish – and invests accordingly. Profits stand to be made whenever a trade finishes in the money, regardless of the direction it moves. The actual contract that is taken out is on the asset price, not on the asset per se.

The most popular types of CFD options are those placed on a variety of commodities like wheat, coffee, soybeans, gold, silver and others. Commodities cannot be purchased and held in their physical form so traders and investors have found unique financial instruments to trade huge quantities of these financial assets, notably futures contracts and CFDs. While these two derivatives trading instruments share many striking similarities, they are different. CFDs are somewhat more flexible than futures and thus preferred by many traders.

How to Profit Off CFDs?

A trader selects an asset and chooses which direction the price is expected to move. For bullish prospects prices should appreciate and for bearish expectations prices should depreciate. Taking a long position is bullish while taking a short position is bearish. It must be remembered that either option can generate profits provided it has been called accordingly. Profits are calculated by subtracting the price at maturity from the purchase price for both long and short positions. If the asset’s price movement met the CFD trade’s conditions, then that price adjustment will be multiplied by the contract size for total profit.

It is entirely possible to lose money on CFDs too. Too many inexperienced traders believe that it’s a walk in the park to simply start ‘betting’ on which direction prices will move. This is a skill that requires reading and understanding. Regular market updates, critical analysis, market insights, and an understanding of the asset class in question can certainly help to improve the likelihood of calling it right. When you buy a CFD contract, you are taking a position on a much larger trade. This is called margin and it works with leverage. The benefits of leveraged trading can result in windfall profits when markets move with you but can also reverse sharply and result in significant losses. Fortunately, many CFD brokers have strict rules on negative balance protection to prevent traders from going under.

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