Meaning of CFD
According to abbreviationfinder, CFD stands for “Contract for Difference”. With a CFD, investors can make profits by speculating on price changes. Contracts for difference are particularly attractive because they are characterized by a high level of leverage. This means that even a low capital investment can bring high profits. However, leverage can also have a negative effect: If the price does not develop as hoped, investors can quickly lose large sums of money. Therefore, CFDs are not suitable for beginners, only for experienced investors.
- With a CFD, investors and providers agree to swap money and base value at the beginning and end of the term of the CFD.
- In order to be able to trade with CFDs, the trader must deposit a security deposit (“margin”).
- CFDs work with a high leverage effect, which multiplies the margin and moves large sums in the market with little capital investment.
- This mechanism makes CFD trading attractive, but it also carries a great deal of risk.
What exactly is a CFD?
CFDs belong to the category of derivative financial instruments and are highly speculative. Every CFD is a contract between two parties: the investor (or trader) and the provider (or market maker). You speculate on the price development of a certain base value and agree to exchange money and base value at the beginning and end of the term of the CFD. Various trading values are used as the base value, for example stocks, commodities or currencies.
The investor can open a long position or a short position. In the case of a long position, he expects the price of the corresponding underlying asset to rise and buys it. At the end of the CFD he sells it again and in the best case makes the previously speculated profit. With a short position, the investor expects falling prices and sells the value in order to buy it back later at a lower price, which results in a profit if it is successful. Speculation is based on various indices.
CFDs are short-term speculative transactions that are often completed within a day. Accordingly, the prices are exposed to strong fluctuations, which increase the risk of loss. If you want to hold your position overnight, i.e. beyond the close of trading, you have to make compensatory payments. The amount of these payments results from the respective calculation basis, the holding period and the position size at the close of trading. The following applies to short positions: If the reference interest rate exceeds the discount, the investor receives a credit.
The transactions take place over-the-counter (OTC). Not every platform allows CFD trading. The broker comparison shows where CFDs can be traded .
Important terms relating to contracts for difference
Investors who want to trade CFDs should know the following terms:
- Margin: The margin is a security deposit that the trader deposits when opening a position. How big this has to be depends on the underlying asset being traded. The margin is tied to the respective position; The investor can invest the untied capital in further positions.
- Leverage: By providing security, investors leverage their capital many times over. For example, if the margin is 1 percent and you bet 100 euros, you can move a capital of 10,000 euros.
- Stop Loss: Traders set a stop loss limit at the point where their position should be automatically closed if the price should develop in the opposite direction to expectations.
- Base value: The base values are the actual trading values. These are, for example, indices, stocks, commodities or currencies.
- Intraday trading: The investor opens his position at the beginning of the day and closes it again at the end of the day. So he carries out the CFD business within a day. This practice is common for short-term speculations.
- Overnight position: If a trader holds his position beyond the respective close of trading, it becomes an overnight position. Compensation payments are due for this.
- Diversification: In order to increase their chances of winning, investors often open several positions on different markets. In this way, you distribute your capital over several underlyings and a single loss is less significant.
Risks when trading CFDs
Trading Contracts for Difference is a very risky business. The high leverage can on the one hand bring high profits, but on the other hand lead to large losses. The available total capital is often smaller than the lost amount, which leads to a total loss. However, the account cannot be overdrawn and private investors are not obliged to make additional contributions after a decision by BaFin since August 10, 2017. That at least limits the incalculable risk of loss.
What happens in the event of a total loss?
If the loss exceeds the capital available on the CFD account, the bank usually arranges for a forced closing; that is, it closes all open positions of the investor. Before the deposited security deposit is used up, the bank also warns with an initial margin call when 80 percent of the credit has been used up. A second margin call follows at the 90 percent limit and at the same time announces the impending forced closing.
Some of the other risks associated with CFD trading include:
- Overnight risk: Investors cannot react immediately to price changes in positions held overnight.
- Market price risk: Underlyings can change.
- Liquidity risk: In the event of market disruptions and outside trading hours, investors cannot open or close positions.
- Day trading risk: If a trader makes losses within a day and tries to compensate for them with even riskier new deals, the loss can multiply in the event of failure. The high level of trading activity can also lead to high transaction costs.
- Bank or market maker insolvency.
- Organizational and operational risks.
How can the risks be reduced?
The risks involved in trading Contracts for Difference are great and varied. However, through skilled risk management, investors can limit the risk of loss. Before opening new positions, they calculate the profit factor – using the value of the winning trades and the value of the losing trades as well as the average profit and average loss. If the profit factor is greater than 1, the trader can make money, so his plans are profitable. In addition, he should define an initial risk that he is maximally willing to take and set a stop loss accordingly.
A proven money management model is the “1 percent from the account” model. Investors choose a risk of 1 percent for each position. Another means that reduces the risk of loss and increases the chances of winning is diversification.