Trading strategies for CFDs
CFD Trading Strategies: Long, Short, and Insurance Positions
A contract for difference (CFD) is an agreement between two parties, usually a CFD trading firm and a securities trader, which specifies a payment to be made if a financial asset or group of investments changes in value. Unlike futures options, CFDs do not require that either party be able to deliver the financial security or securities at any point; CFDs are concerned only with the increase or decrease in value of the given assets. CFDs are purely financial derivatives and are traded on margin; they allow traders to take a position in the market without a large initial investment, which accounts for a measure of their popularity.
Typically traders take either a long position or a short position on the market security or index. A long position indicates a belief on the part of the securities trader that the value of the asset or assets will increase; by buying CFDs from a CFD provider, they can sell them back at any point. Short positions demonstrate the trader’s belief that the security’s value will decrease; by selling CFDs at the current market price, the trader will pocket the difference between the initial sale price and the sale price at the time the position is closed.
Financing charges accrue nightly until the CFDs are sold; this represents the profit of the CFD provider. Investors must maintain a sufficient account balance to meet the margin, or potential for loss; if this margin is not adequate to cover the potential losses for the current market value of the financial security in question, the CFD trading company has the option to liquidate the CFDs held by the trader and close the transaction at that point. Total losses sustained by the trader may far exceed the initial investment; for this reason CFD trading is considered to be high-risk.
Some companies engage in CFD trading as a hedge against possible detrimental events. By taking a short position in CFDs, managers can protect the company against possible losses by effectively insuring the company against them. If the worst occurs, the company can recoup its losses without a large initial investment, providing funds when they are needed most. This strategy protects the company’s liquidity in the event of a serious fall in the price of its stock, often at lower cost than traditional insurance plans.