How is CFD Trading Different from Buy and Hold Investing?

Are you looking to invest in the capital markets? If the answer is yes, you need to ask yourself this question. Am I looking to actively trade? Or, am I looking to passively invest. A buy and hold strategy can work very well especially if you have long-term goals.

What is Contract for Differences?

A contract for differences is a financial security that tracks the movements of an underlying asset. For example, a gold CFD moves in tandem with gold prices. Instead of owning an asset, you own a contract that allows you to benefit from any differences that occur in the price. You can trade CFDs, both selling and buying contracts. Additionally, contracts for differences are margined instruments that provide you with leverage.

What is Leverage

Leverage is your ability to increase the amount of capital you are trading using a financial product. For example, you can control up to 400-times the amount of capital that you post on a trade. The normal margin number of 0.25%, reflect the percent of capital you need to post to place a EUR/USD currency trade.

The leverage that you experience can increase the rate of return you experience. For example, if you post $100 and leverage 100-1, you can control $10,000. If you make 1% on a trade, your return on your posted investment is 100% ($100 / $100). Remember, leverage is a double-edged sword. You can also lose 100% of your investment with a 1% adverse move in the security you are trading.

The leverage your broker will provide is based on the volatility of the underlying security. For example, cryptocurrencies, can experience historical volatility that is larger than the volatility experienced in sovereign currency trading. Therefore the maximum leverage for most cryptocurrencies is near 10-1 compared to 400-1 for sovereign currencies.

Why Are CFDs Beneficial?

Since you can use leverage to trade CFDs and don’t have to post the amount of capital you would need to purchase shares or currencies, you can more efficiently allocate your assets. Generally, when you purchase stocks, you need to post nearly all the value to trade the stock. This could create a situation where most of the capital you hold is allocated to purchasing stocks. Instead, if you use CFDs, you can allocate capital to multiple strategies. You can even use CFDs to emulate a buy and hold strategy.

Take Away

CFDs are financial securities that allow you to invest in the capital markets. The benefits of using CFDs is that they provide leverage. Leverage is used in conjunction with a margin account. Your broker will allow you to post a portion of the value of the CFD, which can enhance your returns. By only posting a portion of the capital you need to control larger notional amounts of capital, you can invest in many strategies. You can even emulate a standard buy and hold strategy using CFDs. The leverage that you are offered to trade will be dependent on the volatility of the underlying product that you are trading. Generally, the higher the volatility of the asset, the lower the leverage that is offered. Remember, leverage is a double edge sword. Not only can you enhance your returns, you are also increasing your risk and your potential loss.