Forex and other financial markets provide a large number of opportunities to make money, including trading currency pairs, indices, precious metals, and shares of well-known companies. However, CFDs are one of the most popular tools among traders worldwide.
CFD stands for contract for difference and is based on the underlying asset’s price. It can be stocks, indices, currency pairs, and other commodities. When trading CFDs, a trader earns on price fluctuations and can speculate on their rise and fall.
CFD trading works according to the following principle: you choose a trading asset and, with the help of technical and fundamental analysis, predict in what direction the price will move in the next minutes/hours/days. If your prediction turns out to be accurate, you get a profit for each minimal change in the price of the asset in your direction (pips).
For example, you believe that the precious metal gold (XAUUSD) will rise due to geopolitical tensions and a number of technical signals. You enter a CFD contract for the gold price to rise, set take profit, stop loss orders, and open a buy order. If the price of gold really starts to grow and the deal is closed in your favor, the broker pays the difference between the current price and the opening price.
The peculiarity of CFD is that you do not trade the asset itself but only its contract based on its price. That is, the trader earns on the underlying asset’s price without owning the asset itself.
A contract for difference is a derivative financial instrument based on the change in the underlying asset’s price. At the same time, it does not provide any rights to own the asset.
Historical Background. Contracts for difference appeared in England in the early 90s to avoid paying stamp duty. Since this way of making transactions does not imply ownership of shares, CFDs were not subject to this tax. Hedge funds were the first to use this instrument, and later it became available to retail traders. Back then, trading consisted only of buying and selling the difference in the value of shares. Today, brokers offer CFDs for almost all commodities.
Why is it profitable to trade CFDs?
CFD trading is very popular. Among the advantages:
- You can trade an asset without actually owning it and profit only on the price difference.
- CFDs are useful tools not only for long-term but also for short-term investments.
- You can make money on various assets: stocks, precious metals, indices, and currency pairs.
- The term of the transaction is not limited, the contract can be closed at any time.
- CFDs can be used for hedging since you can go long or short positions.
- CFDs are traded on margin, just like currencies on Forex. You don’t have to have a large initial capital to start trading.
