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How CFDs Work

Contracts for difference have proven to be something of a boon for traders in recent years, providing an alternative leveraged product with a degree of flexibility and a preferential tax treatment to trading in shares. While contracts for difference are by no means an easy instrument to trade successfully, they do have a number of key benefits to bring to the table, and the possibilities with trading CFDs are limited only to the extent of your appetite for calculated risk and your ability to pick up on winning trends ahead of time.

But before we turn to the intricacies of CFD trading, and particular strategy options you can employ for greater consistency, it's important to ensure a thorough understanding of CFDs at their most basic level - what they are, how they work, and how they piece-in to the overall trading picture.

Contracts for difference are essentially contracts made between a trader and a broker that create an obligation to settle on the difference between the current price of an asset or index and the price stipulated on the contract at its point of formation. In more simple terms, a CFD is an agreement to pay or receive the difference in price from the point at which the agreement was made to the point at which you decide to close out - hopefully banking a profit in the middle-ground, providing markets move in your favour.

The contracts themselves are traded, rather than the instruments to which they relate. So, for example, a contract for difference on BP shares doesn't actually involve the acquisition of any BP securities, and you receive none of the corresponding shareholder rights and responsibilities by entering the position - the contract is merely derived from the underlying security, responding in value to factors affecting the underlying asset price.

CFDs are generally traded off-exchange, and are fundamentally margined products. This means they allow traders to invest in positions more heavily than their available capital would allow, making up the difference in short-term financing provided by the broker. While this naturally incurs higher transaction costs, it gives the trader the opportunity to augment any winnings and ramp up the earnings potential of any given trade.

As a trader, you will be offered CFDs with both long and short positions, allowing the flexibility to either back a winner or piggyback a loser depending on market and economic indicators. You either buy a CFD in anticipation of a rising index level ("go long"), or sell a CFD if you expect markets to fall ("go short"), ideally closing out when you're in a position to lock in a profit in either direction. With leverage on your side, the difference payable can often far outstrip the PIP ("percentage in points") increase in value of your CFDs, thus even small price movements can create significant changes to the value of a holding.

CFDs trade on a wide variety of bases, and have grown to become increasingly widely utilised by more savvy traders. From securities to commodities, from forex to just about any index you can think of, contracts for difference are traded on the same basic principles, and you're really only limited to trading on the bases offered by your CFD broker. While most brokers offer comprehensive coverage of the most commonly traded CFD bases, it is perhaps worthwhile to shop around before signing up to find a broker with the widest selection of contracts on offer.

Compared to dealing in shares, CFDs can be a great way to take advantage of more predictable market movements, and brings both profit and tax advantages to the table. Because CFDs are highly leveraged, the profit potential is often greater than 20 times more when trading CFDs, and for those looking to trade on indexes lower margin requirements make even greater multiples a realistic possibility. Furthermore, with no stamp duty applicable on CFD trades, there is a potentially significant saving to be had for larger scale investments.

Of course, CFDs are not without their fair share of risks, and some would argue that CFDs present a greater risk profile than many other tradable instruments. By virtue of employing leverage, losses are multiplied in equal proportion to upside gains, and as a consequence traders are not automatically limited in liability to their investment. This often requires additional deposits to cover margin requirements and prevent early closures of otherwise profitable positions, and without due prudence and caution losses can become significant.

Having said that, CFDs nevertheless offer traders a flexible alternative to other trading instruments, and once the basics are understood, they can prove a valuable additional tool in building a sustainable, profitable trading portfolio.

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