As the name implies, it’s a contract between you and a broker who sells CFDs, with your profit or loss being the difference in price between the time when a trade is entered into, and then time when you exit the trade.  You’re literally exchanging the difference between those two values with your broker.

There are all sorts of CFDs including:

• Commodity CFDs (contracts that track specific commodities like soybeans, wheat, oil, etc.)
• Foreign Exchange CFDs (contracts that track currency pairs)
• Index CFDs (contracts that track a specific index, like the S&P500, the XJO, etc.)
• And Share CFDs (contracts that track the stock of a specific company)

As a contract, this is not the same thing as simply buying a share of stock in a particular company, although the CFD’s price mirrors the actual stock price, moving in the same direction, because the CFD's value is based on the underlying asset.

The first question you might ask then, is why bother to buy a CFD if you can just buy the asset itself?

It’s an excellent question.  The main reason is that CFD margins are smaller, which means you have to spend less money to control the asset in question.

The best way to see this is to look at a conjectural example.

Let’s say you’re buying 100 shares of stock at $25. The total value of that investment is $2500.  A traditional broker usually uses a 100% margin.

Now let’s look at the numbers if you buy a CFD, rather than the stock itself.  Most CFD brokers only use a 5% margin, which means that you could buy the same investment with an outlay of just $125.  Big difference, right?  Which means that you can buy a lot more investments with whatever amount of money you’ve got.

Let’s start the clock and move through time, beginning from the point when you finalize your purchase.

Your broker gets a either a fixed dollar commission or the spread. Let’s say the spread is 5 cents, (Or Pips for Forex) so if the underlying stock appreciates by 5 cents after you enter into the contract, congratulations!  You just broke even.  If the underlying stock continues to appreciate, everything after that is pure profit when you close out the contract (sell).  So let’s say the stock appreciates to $26. You’d see a profit of $0.95 per share, 100 shares, or $95 ($1.00, minus the 5 cent spread).

What we’re really talking about here then is leverage.  That’s the biggest advantage that CFDs offer over more traditional investments.  The smaller the margin, the more leverage you’ve got, which allows you to control more assets with less money, and that’s huge.

Here are some of the other key advantages to CFD trading in general:

• Global Reach – Most CFD brokers offer products from all over the world.  That means one-stop shopping for you.  You can take advantage of any opportunity from most of the world’s major markets, without ever leaving your broker’s platform.
• Fewer Rules and Regulations – Sometimes, depending on what, exactly, you are buying, you’ll face a dizzying array of rules about what you can and can’t do.  Many instruments, for instance, prohibit short selling at certain times, or have different margin requirements. 
  While you’ll find a few rules in the world of CFDs, they are generally very few in number, and won’t cramp your style.  This is especially true when selling short, because since you don’t actually own the underlying asset, you can short CFDs at any time.

• Full Service – Most CFD brokers offer the same types of trades as traditional brokers, including, but not limited to:  Stops, limits, and congruent orders, and possibly (but not always) guaranteed stops.
• Extremely Low Fees – The fees charged by CFD brokers tend to be significantly lower than the fees charged by traditional brokers.  An important rule of business is “keep your fixed costs low,” and low fees = low overhead costs for you!
•  No Day Trading Requirement – This is huge.  Some markets require a minimum amount of capital if you want to day trade, and the dollar value is usually pretty high, which shuts many novice investors out of the game entirely.
  That’s not the case with CFDs.  Accounts can be opened for as little as $1000 in some cases, although this will vary from one broker to the next, with some brokers requiring up to $5000 to set up an account.  Even so, this is a fairly modest sum by comparison.

• Lots of Different Trading Options – See above, re: the different types of CFDs you can invest in.  You have a full menu of choices available, and aren’t restricted to just trading in stock CFDs (although stock CFDs are a great way to get your feet wet!)

It all sounds almost too good to be true, and it’s true that CFDs represent a tremendous investment opportunity, but…and you knew there’d be a “but,” didn’t you?  There are downsides, and before you jump into the world of CFD trading, you need to be aware of them.

The first downside is the spread.  Because you have to pay the spread, it means that CFDs aren’t very good if you’re after micro-profits…that is to say, tiny movements in price from one hour to the next.  The spread will invariably eat those kinds of profits up, and if you try to take advantage of small moves like that, you’ll consistently lose money.

The other big disadvantage is something we’ve talked about before:  Leverage.

Leverage is a two-edged sword.  When you trade at a profit, leverage will magnify the return on your investment, but don’t get cocky!  The same leverage that helps you when you’re winning can burn you badly on losing trades, where they magnify your losses, which means you’ve got to be very careful to manage your risk if you want to be successful.

Later on, we’ll talk at some length about things you can do and strategies you can employ to help minimize your risks.  For now, it’s enough to be aware that they exist.  When used correctly, leverage can be a powerful tool that will help you achieve your goals much more quickly than would otherwise be possible.

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Differences Between Buying CFDs And Various Underlying Assets

Earlier, we listed various types of CFDs you can purchase, and now that you’ve got a better understanding of what they are in general, we need to spend some time talking about how each of those types differ from simply buying the underlying asset.

Share CFDs

We’ll talk about share CFDs first, because they’re the easiest to understand and are where most people start out when beginning to invest in CFDs.

If you’ve purchased stocks, then you already know just about everything you need to know about buying share CFDs.  The process is functionally similar, but there are some important differences to be mindful of.  These include:

• No ownership – when you buy a share of a company’s stock you physically own a tiny portion of the company in question.  That’s not the case when you buy a share CFD.  You simply own a contract that is in no way connected to the company’s stock (the underlying asset), even though the price of the CFD mirrors the company’s stock price.
• Much lower commissions – Buying stock carries much higher commission rates than buying share CFDs.  Expect to pay about half commission rate.  That’s huge, because lower commissions equal higher potential profits for you.
• Lower margins – We mentioned this above.  Many stock brokers require as much as a 50% margin in the US and 100% in Europea and Asia.  CFD brokers require something margins from 1% and upwards.
• Financing – A small fee your broker may charge you to hold a position overnight

Commodity CFDs

As we mentioned earlier, for any commodity you can buy outright on the market, you can buy a CFD.  We mentioned a few earlier, but here’s a more comprehensive list, in case you’ve never traded in commodities before:

Cattle  |  Cocoa | Coffee | Copper | Corn | Cotton | Gasoline | Gold | Hogs | Lumber | Oats | Oil | Palladium | Platinum | Pork Bellies | Silver | Soy Beans | Sugar | Wheat

And so on.  As you can see, there’s no shortage of options here, and this is only a partial list!

So the next logical question is, “What exactly is a commodity?”  You already know that Commodity CFDs are contacts that track the underlying asset, but if you’re considering trading in Commodity CFDs then you need to understand the underlying product as well!

To that end, here’s the shortest, simplest definition of a commodity.

It’s a hard asset.  A physical product people purchase on futures markets.  They’re bought, sold, and traded in large quantity with uniform quality.  What that means is that anything on this list can be made, grown, mined or generated anywhere in the world, but the uniform quality ensures that no matter where the good is produced, an apples-to-apples comparison can be made.

Here are the key differences to keep in mind when purchasing a Commodity CFD versus purchasing the underlying commodity itself:

•  When you buy a commodity outright, it will come with an expiry date, something you don’t have to worry about when you buy a Commodity CFD
• If you want to break into the commodities market directly, be prepared to spend a ton of money.  $20,000 is considered a pretty small contract, and they can run to about ten times that value.  For most investors who are just starting out, that’s a lot of money!  Again, Commodity CFDs can be purchased with a much smaller outlay
•  Charting – If you don’t have a lot of exposure to commodities trading, then you’re probably going to want to read this twice.  Commodities are priced on the futures market, but all the contracts traded on the futures market have a different expiry date.  This can be seen on comprehensive pricing charts that track commodity prices.  The charts used for commodity pricing display two months’ worth of information, but Commodity CFD pricing is based only on the current month.  If you want to base your buying and selling decisions on more complete information, then in most cases, you’ll need to get that information from a source other than your CFD Broker.

Note:  Commodity CFDs are NOT recommended for people who are new to CFDs in general.  You need to have a deep understanding of the general commodities market and what you’re indirectly trading in before wading into these waters!

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Foreign Exchange CFDs

You’ve probably heard the term “Forex.”  That’s the shorthand used when referencing currency exchanges, and in particular, simultaneously buying one currency, then selling another currency to profit from the movement between a given currency pair.

In many ways, currency trading is a lot like a drug.  Its fast paced and always on.  Since currency trading isn’t done through a central exchange, you can do it 24/7.  There is no “closing bell” here, and fortunes can be made and lost in the blink of an eye.  It’s seldom that someone buys a currency position and holds it for more than a day.  Often, they’re closed back out within hours, minutes, or even seconds.

It’s explosively volatile, and is one of the single largest over the counter market on the planet.  Trillions of dollars flow this market, get updates Bank for International Settlements BIS 

The foundation of currency exchanges are currency pairs, and these come in two flavors:  Pairs and Crosses. 
Here are the major currency pairs:

• EUR | USD
• GPB | USD
• USD | CHF
• USD | JPY
• USD | CAD
• AUD | USD
• NZD | USD

And here are the crosses. 
Crosses are different from major pairings in that the US Dollar is entirely absent from the pairing:

• EUR | CHF
• EUR | GBP
• GBP | AUD
• AUD | JPY

The position of the currency in each pairing matters.  The first currency listed in the pairing is called the Base Currency (also known as the Primary Currency), and the second is called the Quote Currency.  Currency pairs are quoted out to four decimal places, and each point of movement is referred to as a “Pip.”

Here’s how the terminology is used.  Let’s say that for the pairing AUD à USD, the price is .9400.  If the price moves to .9401, then it has moved one pip.  This lies at the bedrock of forex trading.

When trading currency, the prices you see listed on your broker’s information screen come from the biggest banks and corporations on the planet who are moving hundreds of millions, if not billions of dollars at a time.  This is literally the grease that keeps the wheels of international trade and investment turning, and either directly or indirectly, you can be a part of it, if you want to.

There are some seriously compelling reasons to want to, even though it is a highly speculative market. 
Its major advantages are:

• It’s an “always on” market, with no closing bell
• Has extremely low margins, paired with flexible position sizes
• Is entirely commission free
• And it’s the most liquid market on the planet

All of those are good things, and compelling reasons to consider jumping in, but of course there’s a downside.

All that volatility carries with it extraordinary risk.  It takes a steady hand and nerves of steel (and preferably a huge supply of Red Bull, strong coffee, or other highly caffeinated drink) if you want to do well here, and for these reasons, it’s not a good fit for the novice investor.

Our advice would be to get your feet wet via Share or Index CFDs, learn how to make money consistently there, then perhaps move into strategic Commodity CFD trading, and only once you’ve mastered that should you consider jumping into the wild and wooly world of Foreign Exchange CFDs.

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Index CFDs

Index CFDs are functionally quite similar to Share CFDs, but where the latter track against shares of a particular company, the former track against an index, so what is an index, exactly?

Simply put, it’s a group of shares in companies that have a common element.  That commonality could be that they’re all tech companies, or all pharmaceutical companies, or something else.

The Dow Jones Index is comprised of the 30 biggest companies in America, and the price of the index is weighted according to the size of each of the companies that make up the index.  Put another way, if the majority of the shares in the companies that make up the index rise, then the value of the index will rise in tandem.  If a majority of those shares fall, then the value of the index will fall by a corresponding amount.

If you’ve had at least some exposure to the world of investing, then you’ve probably heard of Index Funds.  These are funds that buy stocks in the companies of a particular index, and see their performance mirror the performance of the index as a whole.

They’re great investment opportunities, because by buying into an index fund, you automatically gain a certain amount of diversity in your portfolio that you simply don’t get if you buy stocks in one specific company.

Index CFDs offer the same basic advantages, which makes them a compelling choice to consider, and not markedly different from Share CFDs, which means that they’re newbie friendly.  Another huge plus.

Here are some of the bigger indexes from around the world that you may have heard of:

• Australia’s XJO
• China’s Shanghai Composite
• France’s CAC 40
• Germany’s DAX
• Hong Kong’s Hang Seng
• Japan’s Nikkei Index
• Singapore’s Straits Times
• The UK’s FTSE
• The US’ NASDAQ
• The US’ Russell 2000
• The US’ S&P 500