In finance, contracts for differences (CFDs) – arrangements made in a futures contract whereby differences in settlement are made through cash payments, rather than by the delivery of physical goods or securities – are categorized as leveraged products. This means that with a small initial investment, there is potential for returns equivalent to that of the underlying market or asset. Instinctively, this would be an obvious investment for any trader. Unfortunately, margin trades can not only magnify profits but losses as well.
The apparent advantages of CFD trading often mask the associated risks. Types of risk that are often overlooked are counterparty risk, market risk, client money risk, and liquidity risk.
KEY TAKEAWAYS
- A contract for differences (CFD) allows a trader to exchange the difference in the value of a financial product between the time the contract opens and closes without owning the actual underlying security.
- CFDs are attractive to day traders who can use leverage to trade assets that are more costly to buy and sell.
- CFDs can be quite risky due to low industry regulation, potential lack of liquidity, and the need to maintain an adequate margin due to leveraged losses.
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