If you’re interested in investing, then the chances are that you will have heard of CFD trading from one of the many television or online investing adverts we hear and see almost every day. But what exactly are CFDs, and why do people choose to trade them instead of trading on the ‘normal’ stock market? First of all, we’ll give you a simple explanation of what CFDs are and then we’ll look at why some people choose to trade in this way.
What are CFDs
CFDs – also known as Contracts for difference – offer traders an alternative way to trade in an asset or share, without having to actually purchase the physical share itself. Instead of trading in physical shares, you will instead trade ‘units’ of an underlying asset such as shares, commodities, foreign exchange or even full indices such as the FTSE 100 or the Dow Jones Industrial Average. It’s important to note however that since no physical asset is actually being purchased, the unit price may not always completely reflect the actual price of the asset. It usually does reflect it, but this is not guaranteed.
So now you have a basic understanding of what CFDs are, let’s consider why some people might choose to trade them.
As we mentioned a moment ago, when you trade in CFDs, you don’t actually purchase any physical assets. Because of this, no stamp duty is levied on this type of trading. This is one advantage of trading CFDs.
The ability to go short, as well as long
If you tend to keep your eyes peeled to investing news channels, then you may have noticed that some investors have made the majority of their money not by finding shares that have risen drastically in value, but they have instead made their money by shorting shares which they think are going to fall in value. Trading CFDs can allow investors to ‘short’ a particular share and make a profit if its value falls. This means that it is possible to make money in both a rising and a falling market. You can also use CFDs to ‘hedge’ your existing physical portfolio, but that’s a subject that is probably best covered in a separate post.
The ability to leverage
One of the other main reasons people choose to trade CFDs is that they are able to use leverage. If you are new to the concept of leverage then imagine you have £100 to invest, but you are so confident that a share is going to rise or fall in value that you wish that you had £2000 to invest, as you know that if the share price moves as you expect it to, then your returns could be so much bigger if you had more money to invest. This is where leverage comes in. When you trade CFDs through an appropriate online platform, your chosen platform will often be willing to let you trade ‘on a margin’, effectively lending you the extra money you need in order to amplify your potential returns. It is important to realise, however, that if the share price moves against you while trading on a margin, then this could also magnify your potential losses too. You can read more about how leverage works in the CFDs section on the CMC Markets website.
So, there we have a basic explanation of what CFD trading is and also why some people might choose to trade in this way, rather than buying physical shares. If you are thinking about trading CFDs then be sure to fully research the market, to ensure that you have a full understanding of the potential pros and cons of this type of trading.