Across the globe, millions of trades are taking place every day, in various different forms. Trading in financial markets can offer countless opportunities to make potential profits, and expand your trading portfolio, with every trade pursued.
However, trading can be a highly complex process, as there are many different forms of trading you can do. There is, of course, traditional trading, but it’s also worth considering this alongside one of today’s most popular forms of trading – contracts for difference (CFDs).
This article will outline the main differences between traditional trading, and the process of trading with CFDs, in the hopes you have a clearer understanding of how they work, and which one – if not both – may be better suited to you.
The ownership of an underlying asset
When trading in the traditional way, this involves the ownership of the underlying asset. This means that the underlying asset, in its entirety, belongs to you, and your profit is determined by the value of this asset rising of falling.
However, when you trade with CFDs, you don’t take any ownership of the underlying asset, but instead purchase contracts (units), and speculate on their price movement. With CFDs, you are essentially predicting the value of the asset, instead of owning the asset itself.
For instance, you might open a long (buy) position on an asset, which means you are predicting the price will rise. As the value of the asset rises, you will profit accordingly. If it doesn’t, however, you will equally incur a loss instead.
With a short (sell) position, the process is identical, except for the profit coming when the asset decreases in value, instead of rising.
Leveraged trading
The next significant difference between CFD trading compared to traditional trading, is the inclusion of leverage.
With traditional trading, you must deposit the full amount of capital to open a position in the market. With CFD leveraged exposure, however, you can open up a position on a particular asset without paying the full price. Instead, you pay a specified deposit known as a trade margin.
The margin will be established by the leverage ratio of the asset, which determines the level of exposure you gain for the amount you put down.
For instance, let’s say an asset has a leverage ratio of 1:30. This means you can put down £1,000, and open a position worth up to £30,000. As for the margin, a leverage ratio of 1:30 would mean that a trade of £90,000, would need a margin of £3,000.
Do be aware, that leveraged exposure works both ways – should you make a loss on this trade, this is calculated from the full amount of the investment, not just the original margin.
Potential for profit on every price movement
The final main difference when trading CFDs instead of traditional trading, is the opportunity to make a profit regardless of the price movement.
When you own an asset in traditional trading, your profit is determined by the overall value of that asset. If the asset value rises, so does your profit. If it falls, you incur a loss.
With CFD trading, you are able to open a specific position on an asset, which speculates the price rising or falling. Therefore, you might open a long position, and gain a profit as the price rises – or loss if it falls. Or, you might buy a short position, so even if the asset value falls, you can still make a profit.
This is highly beneficial for traders, as it doesn’t restrict you to only making a profit on a rising market. However, you have to be strategic in opening the right position.
Some traders even use hedging, which is a technique that involves opening a CFD short position on an asset you already own, if you think the value will decrease. Therefore, although you may receive losses on the asset you own, you can also gain some profit on the CFD you opened, thus mitigating the damage.
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CFD and traditional trading are both fine options for professionals around the world, both experienced and beginner traders. However, with their vast differences, you may find that one particular form is better suited to your needs and financial goals.