Flexibility and ease of use make CFDs a natural choice for those looking to profit from rises or falls in the value of a given asset. At the same time, CFDs can also be used to hedge risk from other investment positions.
The rise of instruments such as CFDs means that derivatives trading is no longer just for institutional investors or the elite.
CFDs as derivatives
CFDs are a type of derivative. But what are derivatives anyway?
Think of derivatives as a way of gaining exposure to a particular asset but without having to actually buy or sell that asset.
Derivatives are essentially contracts on a given financial asset. For instance, this could be a company’s shares, a stock market as a whole or a commodity such as oil.
These days, derivatives such as CFDs allow investors to open and close positions on such underlying assets at the touch of a button.
CFD stands for Contract For Difference. While CFDs readily provide investors of all types with a straightforward way to profit from upward or downward movements in a given financial asset, they were originally used by institutional investors as a means of controlling risk.
Hedge funds and certain other institutions first began using CFDs in the 1990s as a means of hedging the risk of their long equities positions. By entering into CFD positions that profit from falls in companies shares, they could mitigate the impact from any share price declines.
It wasn’t long though before CFDs began to be developed for a wider group of investors, who quickly appreciated the opportunity presented by CFD trading to maximise profit potential from gains or falls in asset prices.
Perhaps the biggest reason for the rise in popularity of CFDs among investors in general is that it is only necessary to put down a small percentage of the actual trade size.
For instance, using what’s known as margin you could only have to pay as little as 5% of the transaction value to open a position in the CFDs of a company’s shares.
Margin tends to be critical in understanding the profits or losses associated with CFD positions. It has the potential to greatly amplify both.
CFD trading example
Suppose we enter into a long CFD position in ABC shares as we expect the shares to rise. ABC is trading at 980/1000p. This denotes the bid/ask spread, where 980 pence is the sell price and 1000 pence is the buy price. We decide to buy 1000 CFDs.
In this example, the margin will be £500 (5% x (1000 units x 1000p buy price)).
Your expectation was right and the ABC share price moves up over the next hour and you decide to sell your shares for 1030. This means the bid price has increased by 50 pence.
1000p buy price minus the 1030p sell price = 30 pence
Your profit is 1000 units x 30 pence = £300.
You have made a 60% profit on the funds you invested in the space of just one hour.
Suppose, however, that you had been wrong. ABC shares begin to fall over the next hour and you decide to cut your losses when the bid price has reached 970p.
1000p buy price minus the 970p sell price = 30p