Contract for difference (CFD) trading is a popular alternative to traditional investing. Because of its ability to maximize capital investments, CFD trading can increase your potential to turn profits and losses. This approach to forex trading has grown in popularity over the past decade, especially since some brokerage firms offer negative balance protection to limit heavy losses that would place your trading account into debt.

What are the advantages of CFD trading? Let’s take a closer look at what it is and some of its benefits.

How is CFD trading similar to traditional forex trading?

CFD trading shares some similarities to traditional forex trading, such as:

• The process when carrying out trades is similar. 
• CFD trades and forex trades are carried out on the same platform.
• Forex trades and CFD trades are carried out in the OTC market without a central exchange.
• The spread is the sole cost of trading.
• With CFD trading and forex trading, the trader doesn’t actually own the asset. 
• Commissions or broker fees are charged at a certain percentage of the transaction’s total value, but CFD trading fees tend to be much lower than traditional fees. 

What are the benefits of CFD trading? 

Greater Trade Leverage

In more traditional investment vehicles, traders are required to commit 100% of their capital to a trade if they wish to open a position. Think of the standard way most traders purchase stocks: If you want $1,000 of a certain stock, you must put all of that money into the investment.

However, with CFD trading, the current margin requirement to open a position is just 5%. With less capital required up front, traders can increase their potential profit margin. For example, if you want to open a $1,000 position in a forex pairing, you only need to allocate $50 to that investment. Meanwhile, the other $950 remains free for you to commit to other positions.

While this approach can accrue much larger losses, negative balance protection can mitigate some of the risk. This creates a net positive when you’re looking to use leverage to maximize potential gains.

Earnings Potential in Bear and Bull Markets

CFD trading allows you to open positions in both rising and falling markets, giving you the ability to capitalize on any type of market fluctuation.

With greater flexibility in pursuing opportunities, traders enjoy greater control over how, where, and when they open positions in a market.

How can CFD trading profit from falling markets?

With CFD trading during a bear market, a short position is taken when a sell order initiates a trade. That means a trader expects that an asset’s value is likely to decrease over a period of time. If this prediction is incorrect and the asset’s price increases, the trade will incur a loss. This loss is the total difference between the asset’s opening and closing price over the contract’s lifetime.

Flexible Lot Sizes

Given the potential volatility of CFD positions, many brokers offer flexible options when it comes to trade size. By doing so, brokerages are able to accommodate a wide range of traders—especially beginners or casual traders looking to experiment with investment strategies while limiting risk.

While your forex platform and the types of trades you’re trying to execute may restrict lot sizes, CFD trading often allows more flexible lot sizes as traders balance the amount of margin they’re using with the risk they’re taking on. A standard lot of 100,000, for example, represents the number of quote currency units required to purchase your base currency. 

A single unit of GBP is currently worth $1.23. To purchase 100,000 units of the base currency GBP, you would need 123,000 units of USD in a standard lot order. At a 5% margin in a CFD trade, it would be $6,400 to purchase a standard lot. Purchasing alternative lot sizes is also possible, including a microlot as small as 1,000 units.

Since the amount of money being staked to your lot is much smaller than the actual lot purchase, your platform will likely offer more expanded options. Familiarize yourself with these options as you develop your strategy for making a CFD trade.

If you’re new to trading, consider starting with the smallest allowable lot sizes to minimize your risk. As you gain confidence in your trading strategy, you can always increase lot sizes.

Lower Trading Costs

Compared to those of more traditional trading methods, CFD brokerage fees tend to be much more cost-effective. Brokerages typically draw their earnings from daily percentages earned by financing the transaction. For example, when you spend $50 to open a $1,000 position, the brokerage charges a small fee to cover the $950 difference.

In addition, traders usually pay the “spread” on a position when they decide to sell. Always make sure you have a clear understanding of the broker’s fee schedule before you open an account and start making trades. You want to know exactly how you’ll be charged for your trade before you give your money to a firm.

Ability to Keep More of Your Hard-Earned Capital

CFD trading offers more leverage than traditional trading. While standard leverage was once just 2%, it currently falls anywhere between 3-50%. The lower the margin requirement, the higher the potential for returns. 

Broader Hedging Options

Thanks to the limited capital commitment needed to open a position, traders have access to funds that can be used to implement hedged positions and limit their risk at any given time.

This is a useful strategy when you’ve taken a risky position on a CFD or when a long-term position is accruing losses. Instead of selling at a loss and draining your account’s funds, you can open additional positions in the hope that you’ll generate earnings that balance your initial position. When used correctly, a hedging strategy can balance some of the risks that come with CFD trades.

No Expiration Date

Unlike other investment instruments, CFDs don’t depreciate over time. They also don’t have set expiration dates, and they feature far fewer restrictions on closing a position than other types of investments, such as futures.

As a result, traders can be patient when taking long positions. Day traders may not see much benefit, but if you’re able to take a long-term approach to your investment, you can ride the market through multiple cycles and wait until the time is right to sell.

What do you need to remember when trading CFDs?

Now that we’ve examined the advantages of CFD trading, you also need to understand its potential risks and pitfalls. Before engaging in CFD trading, here are some of its accompanying risks and conditions:

• CFDs can put you into debt. If you overextend yourself and suffer major losses, you can lose more than just the principal you’ve invested. If you invest $500 at a 5% margin and purchase $10,000 of a currency, a 30% decline in this asset value—$3,000—would create a net loss of $2,500 that you would be obligated to repay.
• CFDs are highly complex trading tools. Given the risk and complexity of leveraging CFDs for profit, only experienced forex traders are encouraged to try this trading strategy.
  CFD clauses may catch you by surprise. Make sure you know how to read these contracts carefully—otherwise, the rules or provisions of the contract could affect your plans and your net profits.
• A CFD provider represents another kind of risk, known as counterparty risk. Since your contract holder executes the contract, there are many ways the counterparty’s actions could undercut your profit potential. For example, delays in purchasing your desired assets could result in that purchase being executed at a worse price. The contract holder may also close out your position at their discretion, securing losses against your will—and with little option for recourse on your part.
  CFD losses can pile up quickly. Just as quick profits are possible with CFDs, losses can occur swiftly, putting you in a deep hole before you have a chance to react.

There are a number of potentially lucrative advantages of CFD trading. But because of their significant potential rewards, these investments still represent significant risk and need to be carefully considered before a position is opened.

To maximize their opportunities with this investment strategy, traders should follow the best practices of CFD trading, thoroughly research investments before opening a position, and exercise caution when committing capital to any CFD trade. Meanwhile, make sure you understand the fee schedule of your preferred broker and seek out a broker who offers risk-limiting features, such as negative balance protection.

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