A contract for difference (CFD) is a type of derivative product that enables investors to speculate on the price movement of underlying assets without actually owning the asset itself. When trading CFDs, investors can take either a long or short position, depending on whether they think the underlying asset price will rise or fall.

Investors often use CFDs as a hedge against potential losses in their portfolios. For example, if an investor holds a portfolio of stocks and is concerned about a potential drop in stock prices, they may use CFDs to hedge their position. By taking a short position in CFDs, the investor can offset any potential losses from their portfolio of stocks.

The price of the underlying asset may move in the opposite direction to your prediction

When trading CFDs, you are essentially betting on the underlying asset’s price movement. If the price moves in the opposite direction to your prediction, you will make a loss.

For example, let’s say you take a long position in a CFD contract for ABC Corporation shares, predicting that the share price will increase. However, the share price falls, and you close your position at a loss.

You may be subject to margin calls

When trading CFDs, you must post collateral, or margin, with your broker because CFDs are leveraged products, meaning you only need to put up a small deposit, or margin, to trade a much larger contract value.

For example, let’s say you want to trade a CFD contract worth $100,000. If the broker requires a margin of 5%, you will only need to put up $5,000 of your own money as collateral. The broker will provide the remaining $95,000 in the form of leverage.

While leverage can magnify your profits if the price of the underlying asset moves in the direction you predicted, it can also magnify your losses if the price moves against you. Therefore, it’s essential to understand the risks involved before trading CFDs. (getzonedup.com)

You may lose more than your initial deposit

Because CFDs are leveraged products, you can lose more than your initial deposit. For example, let’s say you put down a deposit of $5,000 to trade a CFD contract worth $100,000. If the underlying asset’s price falls by 10%, your investment will be worth $10,000 less than when you started. However, if the price falls by 20%, your investment will be worth $20,000 less than when you started. You must remember that you may be required to post additional collateral if the value of your account falls below the margin call level. Therefore, in a falling market, you could lose more than your initial deposit.

You may be charged fees

When trading CFDs, you may be charged fees for opening and closing positions and holding positions overnight. These fees can diminish your profits, so it’s crucial to consider them when deciding whether to trade CFDs.

For example, let’s say you open a long position in a CFD contract for ABC Corporation shares at $10 per share. The next day, the share price rises to $11, and you close your position. Assuming you don’t hold the position overnight, you will profit $1 per share. However, if the broker charges a fee of $0.10 per share for opening and closing positions, your total profit will be $0.90 per share.

You may be subject to slippage

When trading CFDs, you may experience slippage, which is the difference between the price at which you expect to execute a trade and the actual price at which it is executed. Slippage can occur when there is high volatility in the market or when you try to execute a large trade.

For example, let’s say you want to buy 10,000 shares of XYZ Corporation at $10 per share. However, by the time your trade is executed, the share price has already risen to $10.50 per share. You would have experienced a slippage of $0.50 per share in this case.

Slippage can eat into your profits or increase your losses, so it’s essential to consider when deciding whether to trade CFDs.

Click here to learn more about CFD trading with Saxo.

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