CFDS – Category Page CFDS

Intro

CFDs are one of the most frequently traded financial derivatives in the world. As well as being a staple of traders working for investment banks, hedge funds, and other large financial institutions, they are also popular with private day traders and even retail investors. CFDs were first developed in the 1990s as a more efficient way for traders at financial institutions to take short, leveraged positions on equities, often as a hedge against another larger position in an actual stock held in the same company. Their flexibility led to the popularity of CFDs quickly taking off within the City of London and other financial centers. The rise of home internet access and online investing generally narrowed the gap between the investment and trading vehicles and instruments available to institutional investors and private individuals and retail-facing CFDs trading platforms also quickly appeared.

As a financial derivative, taking a market position using CFDs does not involve owning the underlying asset itself. Rather, the trader simply takes a position on the price direction of the underlying asset the CFD represents, which could be gold, oil, a currency pair or an index such as the Nasdaq or Nikkei. This both reduces transaction costs significantly and makes them a very flexible investment instrument.

Ways CFDs are Used by Traders and Investors

Because CFDs are leveraged, this means profits and losses are multiplied compared to the ‘margin’ a trader puts down like a deposit on the position. Without the correct use of ‘stop losses’, which close a CFDs trade when losses hit a pre-set level, it is possible for the trader to lose more than the originally invested amount. This quality means that CFDs are categorized as a high-risk investment instrument and are most suited to active, experienced investors. However, for experienced investors and those willing to dedicate the time and effort required to be able to trade CFDs responsibly, they have a number of potential uses and advantages.

Hedging: the first way that CFDs can be used effectively is for the purpose they were initially devised for, which is as a hedge against another, larger position. An investor with significant exposure to an asset, such as stock in a company, can take a smaller short position in CFDs. If the share price unexpectedly goes down, the short CFDs position will result in a profit which will go some way to compensating the loss sustained from the main position. Hedging an investment position in this way is like taking out an insurance premium. It has a price attached to it but if things go wrong it protects the holder from a far heavier loss.

Increasing Exposure: the leveraged nature of CFDs means that traders can also use them to multiply the exposure they have to an asset’s price direction. This means the trader is able to make relatively significant returns from relatively insignificant price movements. If we take an example of leverage of 1:10, a CFDs trader would invest $1000 in a particular financial asset but hold a $10,000 position. Without leverage, if the price of the underlying asset moves 1% in the direction the trader has forecasted, they make $10, or lose $10 if it moves 1% against them. However, on a CFDs position employing 1:10 leverage, the $10 gain or loss becomes $100. This allows successful traders a quicker increase of their capital, however the multiplication of losses on losing trades is why CFDs trading is risky.

Spreading Risk: because CFDs do not involve ownership of the underlying asset, opening a position is relatively much cheaper than buying the actual asset. The cost involved in buying company stock means that regularly buying and selling stock often means transaction costs outweigh the benefit of potentially making lots of little profits across a quickly changing portfolio. If the portfolio has lower value holdings, transaction costs can also add up to a significant % of the overall value of each holding, meaning the price has to rise more significantly before a worthwhile profit is made. The cost of taking a CFDs position is a relatively small ‘spread’ between the buying and selling price which means that taking multiple small positions on a wide range of assets and opening and closing them regularly is financially feasible. This means that traders and investors using CFDs can more efficiently spread their risk and not be overly exposed to any one position.

Another aspect of risk spreading is that CFDs give traders access to many more markets. Physically buying a barrel of oil, several ounces of gold, silver or platinum or several hundred bushels of wheat is not convenient, for a number of reasons, even if the buyer doesn’t take physical possession of the commodities. However, CFDs provide traders with an efficient mechanism to still gain exposure to financial markets in these kinds of commodities and other assets its also not practical to actually own.

CFDs Asset Classes

The asset classes that CFDs most commonly cover are currencies, commodities, indices, and equities. However, it is also possible to trade CFDs on alternative asset classes such as cryptocurrencies and even economic data such as GDP growth or unemployment figures, or the outcome of political events such as elections.

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