What is Day Trading?
17 August, 2021
What is the spread?
17 August, 2021

What is a CFD?

A CFD is a financial instrument that reflects the movement in the price of the underlying asset. It allows you to generate profits or losses based on the movements of the underlying asset, however, you are not the owner of the underlying asset.

To put it simple with an example, you could take long or short positions on a Disney share without owning the share. The CFD on that share will replicate the movement of the share price and you could trade that CFD.

How does a CFD work?

As we have already mentioned, a CFD replicates the movement of the price of its underlying asset. In this case, let's imagine that you have a share at a price of US$ 15.60 per share and you decide to buy 200 shares at that price, in that case you would have invested US$ 3,120.

If you buy the shares directly, it is most likely that you will be asked to maintain a margin of at least 50% (US$ 1,560 in this case) for this operation, in the case of a CFD the margin may be much lower until reaching 5 % (US$ 156).

What does this mean?

That you have much more free capital to place in new operations.

Let's continue with the previous example, if you had kept your shares and their price had increased to US$ 17.60 you could have sold them at that price and obtained a profit of US$ 400 / US$ 1,560 = 25.64%.

Now let's see what would have happened if you had traded the CFD instead of the share, let's imagine that you sell the CFD at the price of US$ 17.58 (you discount 2 decimal places for what you have paid in the spread).

In this case, you would have a return of US$ 396 / US$ 156 = 253%.

You have to take other things into consideration like commissions and so on, yet the return that a CFD can generate is significant.

Advantages and Disadvantages of CFD's

Advantage

Leverage: CFDs allow you to work with leverage. Also, margin requirements can be as low as 2%. This also depends on the underlying asset, in some cases it can be up to 20% margin required.

Global access from one platform: Most CFD brokers allow you to trade CFDs on instruments from around the world.

Variety of Options: There are CFDs on shares, indices, bonds, currencies, Commodities and many more.

Disadvantages

Spreads and entry costs: The fact of having to pay the spread at the time of placing a trade makes you start operations with a small spread against it that can affect you if you are looking to generate profits from small changes in price.

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