What is a CFD?

CFD stands for Contract For Difference.

A CFD is a financial instrument which mirrors the movements of the underlying share or index. In recent times the use and trading of CFD’s have grown very popular as more and more individual investors learn the benefits, flexibility and the increased cost effectiveness which CFD’s provide.

CFD’s give the investor the benefits of owning the stock, without the need to invest in the physical share. Its major feature is that it is traded on margin, meaning that it is geared to enable an investor to take out a position with a much smaller capital outlay in comparison to the actual underlying stock.

Example:

If you open a position in a Telstra CFD with $1,000 of equity capital at a margin of 5%, then your effective trading capital is $20,000.

However, as the ability for greater profits generated though the trading of CFD’s is appealing, investors must also realize the increased risk that comes with trading CFD’s. Whilst greater profits can be achieved, the opposing view must also be taken into consideration. A negative movement in the market will also be multiplied and therefore the risks involved are also increased significantly.

The other point investors must keep in mind is that CFD’s can result in looses which exceed your initial deposit as it is a leveraged product. Inexperienced investors must keep in mind that serious looses can be experienced, and that CFD’s may not be suitable for all people. New CFD traders are advised to ensure that they completely understand of the way in which CFD’s work and the risks involved.

The most effective way to demonstrate the severe risks involved with CFD’s is to use the above example. Hypothetically, if you held a stock worth $5 and invested $1,000 (effective trading capital = $20,000) and the stock above were to fall to $0, then effectively you will loose $20,000. This example does work in the opposite way as well, if the stock rises to $10, then your profit on the position will = $20,000.