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CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 67% of retail investor accounts lose money when trading CFDs with this provider. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.
With the explosion of markets and cryptocurrencies in recent months, increasingly more people are looking for ways to trade. Most traders around the world choose contract-for-difference (CFD) trading, which is a specific type of trade that includes trading asset contracts. But before you get started, let’s find out what CFD trading is all about.
What is CFD trading?
As with any investment, you should dive into the basics first. This allows you to invest more safely and minimize your risk.
The definition of CFD trading
CFD is an acronym that stands for “Contract For Difference”. The CFD market can be considered a copy of real markets, except you’re buying a price contract instead of an underlying asset, be it a stock, commodity, indices, or crypto assets. When the price of an asset rises, so does the price of the corresponding CFD contract. The main difference is that when you buy a CFD, you are making a bet on the asset’s price but you do not get to own the asset it represents.
The CFD market covers all kinds of assets including FOREX, fiat currencies, stocks and cryptocurrencies. The easiest way to start trading CFDs is through a reputable platform like eToro.
The principle of CFD trading
In standard trading, you buy a stock or a cryptocurrency. You make or lose money when the price of the asset you bought rises. As such, your earnings are equal to (minus fees and taxes) the gain in its price. In CFD trading, things are a little different. With CFDs, your earnings are based on the absolute “difference” in price, i.e. whether it goes up or down.
For example, with a CFD you can bet on the rise of an asset. If the price of the asset rises, you may receive a profit. But the difference is that with a CFD, you can also bet that a certain asset will lose some of its value. In other words, you can open a short position on an asset that is trading high and bet on it falling. In this case, you will be “shorting” the asset, with the logic of the short contract being that you sell it high and buy it back at a lower price.
In other words, with CFDs, you are betting on a trend, rather than on a price increase.
What are the benefits of CFD trading?
CFD trading has a number of advantages over direct, traditional trading, which is why it is popular amongst investors.
With CFDs, you can bet on rising or falling asset prices
As explained above, CFD trading offers the ability to bet on both the rise and fall of a particular asset. As such, you are free from the market trend. No matter where the market is going, you have the opportunity profit if you’re right, or lose money if you make an inaccurate call.
The leverage effect specific to CFDs
Another interesting aspect of CFD trading is leverage. Essentially, it allows you to borrow funds from a third-party in order to buy a bigger CFD contract. As such, your potential profits might be bigger if you’re right, or you would lose significantly more compared with an unleveraged trade. But how does leverage work in practice?
For instance, let’s say you want to purchase 5 shares of Starbucks in a “non-CFD” market at USD 100 price per share. You would like to spend USD 500 to open a position, which buys you a total of 5 BUX shares. Alternatively, you can choose to buy a Starbucks share CFD with a leverage of 1:50. This means that you will pay only USD 2 of your own money per Starbucks share and your total investment sum will be 50 times higher – you could open a USD 25,000 worth CFD position. As a result, you may profit significantly more from an upwards price move, but mind that you can also lose 50x more if you’re not right. Leveraged trades are extremely risky, and are not recommended for complete beginners.
By minimizing your initial investment, the leverage effect allows you to heighten your gains and losses. The money borrowed for opening a leveraged position must be paid back upon its closing – otherwise, your position, or account might be forcefully liquidated.
Now you know – CFDs can work both ways. In the worst-case scenario, you risk losing your initial investment if the asset price falls. However, most newbies underrate the possibility of losing much more than their initial stake if they are wrong. Remember: if the price does not move in the direction you expect, the leverage effect also applies. IF you bet on a rising price with a leverage of 1:50 and the price falls by 2%, you might lose 100% of your bet.
It is therefore vital that you understand the mechanics involved before you start trading CFDs. In particular, you need to learn how to use stop losses, leverage, and take profit orders to limit your losses or realize your gains.
If you’re unsure if leveraged trading is for you, you don’t have to start investing with real money. Trading platforms like eToro allow you to open a demo account with a valueless virtual currency portfolio to train and acquire basic skills and understanding of the markets before you deposit real money.
Sign up on eToro and get a USD 100,000 virtual portfolio to practice your strategy today!
Disclaimer
- eToro is a multi-asset trading platform that offers both investing in stocks and crypto assets, as well as trading CFDs.
- Please note that CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 67% of retail investor accounts lose money when trading CFDs with this provider. You should consider whether you understand how CFDs work, and whether you can afford to take the high risk of losing your money.
- Past performance is not an indication of future results.
- Cryptoassets are volatile instruments that can fluctuate widely in a very short timeframe and therefore are not appropriate for all investors. Other than via CFDs, trading crypto assets is unregulated and therefore is not supervised by any EU regulatory framework.
- eToro USA LLC does not offer any CFDs and makes no representations, and assumes no liability for the accuracy or completeness of the content of this publication, which was created by our partner using publicly available, non-company-specific information about Toro.
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