Contracts For Difference Or CFDs For Newbies - The Basics ExplainedBy Ashley Jessen | 01 March 2010, 16:02 BST
Introducing CFDs 101. Today we'll go through a basics guide to Contracts for Difference so you can confidently speak the lingo and get your head around the key concepts of this exciting product.
What exactly is a Contract for Difference?
A CFD is a derivative product that derives its price from the underlying market (stock, futures, index or Foreign Exchange) and allows you to trade on margin. In a nutshell, a CFD is exactly like trading the regular stock market, except you only need a small amount of money up front (margin) in order to control the full position.
Are CFDs risky and can I lose all my money?
Many people will tell you that trading a derivative like a CFD is risky and for the most part they are right. What they are missing is the point about who controls the risk. You see with Contracts for Difference you only need say 10% margin up front in order to control your total position. So if you wanted to buy $10,000 worth of BHP share CFDs then you would only need $1,000 of your own money.
This introduces a concept called leverage. In many cases you will be able to trade up to 10 times your account size which means your $10,000 account could hold positions totaling $100,000. Now that is extremely risky and you never wanted to be trading at such high levels of leverage. If you trade in this fashion you could in fact lose more money than what you start with which would be disastrous.
So in order to keep your risk to a minimum you need to trade a zero leverage and treat your account like a share trading account. So with $10,000 cash in your account, do not trade with positions exceeding $10,000. This means you are taking on no more risk than a standard share trading account.
What about CFD Financing?
One of the key differences between standard share trading and trading CFDs is the fact that with CFDs you are in effect borrowing 100% of the total position even though you put up a 10-80% deposit. That is one of the main ways CFD brokers make their money. Your broker will charge you a Contract for Difference financing rate which is usually the current cash rate plus 3% when holding a position long. Your broker will actually pay you the current cash rate minus 3% for short positions which is a nice bonus.
Can I short sell with CFDs?
Yes. One of the greatest advantages of trading this exciting product is the ability to profit when the market is falling. Short selling is alive and well and CFDs have greatly popularized this style of trading. Short selling is the exact opposite of trading long and for many newbies it can take a little time to get your head around the concept.
Action: Discover the 7 most Critical CFD Trading Tips and 2 of the most common CFD Trading Strategies. Learn more about the Contracts for Difference (CFD) revolution by going to http://www.learncfds.com/.
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