What are CFDs on the stock market

If we are involved in the world of finance and stock market investment, or informing ourselves to enter, it is most likely that at some point we have seen or heard something about CFDs. But what are CFDs on the stock market? What do they do? What are they for? While is true that these are somewhat complex investment instruments, We will try to clarify the concept in this article.

In case you want to know more about CFDs, I recommend that you keep reading. We will explain what they are what are its characteristics and the advantages and disadvantages What does it mean to work with them?

What is a CFD and what is it for?

We will start by explaining what CFDs are on the stock market. It is a cash derivative investment instrument. In general, it does not usually have an expiration date and allows you to operate on the movements that prices have but without acquiring the underlying asset.

The acronym “CFD” stands for “Contract for Differences”, “Contract For Differences” in English. What does this mean? Well, it is an existing contract between two parties. Both exchange what would be the difference between the entry price and the exit price. Of course, this number is multiplied by the number of indices or shares that had previously been agreed upon. Thus, profits or losses are related to the difference between the price at which they were bought and at which they were sold.

It should be noted that CFDs are extremely complex instruments and the risk of losing money through them is very high and fast, due to leverage. That is to say: We can maintain a position on a certain asset without disbursing its total cost, if not only the margin required for the operation. Due to this feature, the instrument in question, in this case CFDs, they have a very high risk that the investor could lose their money very quickly.

It is estimated that between 74% and 89% of retail investors who trade CFDs lose money. For this reason, it is of the utmost importance that if we consider trading with CFDs, Let's understand how they work and if we can afford to take so much risk to lose our money.

Features

Next we will comment the characteristics of these instruments to better understand what CFDs are and how they work.

• They allow to obtain benefits in markets both bearish and bullish. They can also be used as a hedge when investing in stocks.
• They are OTC products (Over The Counter). That is, they belong to the unorganized or over-the-counter market.
• As their name suggests, they are contracts for differences.
• The price of each CFD is linked to its underlying. This underlying asset is listed on an organized market. In addition, we know the price of the underlying at all times.
• They are products with leverage.

Now that we have an idea of ​​what CFDs are on the stock market, we can say that they are instruments that allow us to earn a lot of money quickly. But be careful, because just as they can make us earn money quickly, they can also make us lose it. Therefore, before starting to operate with CFDs, we must be clear what are the advantages and disadvantages of them. Below we will list the pros and cons.

Advantages

First we are going to start by commenting on the advantages offered by CFDs:

• The variety of underlyings (stocks, commodities and indices) offered by CFDs is very large and is found in markets around the world.
• They offer the possibility of open long/bullish and short/bearish positions. So we can invest both upwards and downwards.
• They allow the development of various strategies: Portfolio coverage, speculation and investment.
• They perform a direct replication of the evolution of a share, a commodity or an index.
• They have no expiration. Nor is it necessary to change the contract if we want to maintain long-term positions, except in CFDs on currencies and on raw materials.
• Generally, the brokers through which we can operate with CFDs do not ask for a minimum opening amount to start trading, nor do they ask for account maintenance fees.
• They also usually have a free demo account, through which you can make operations without using real money, as a practice and familiarization.

Drawbacks

We are now going to see the disadvantages of CFDs, as it is very important that we take them into account:

• They are difficult products of understanding. According to National Securities Market Commission (CNMV), CFDS are not suitable for retail investors as they carry a very high level of risk and complexity.
• CFD trading require constant vigilance and monitoring of the investment made.
• The risk of losing money trading CFDs is very high.
• Long trades incur a funding cost for CFDs. This corresponds to the part of the investment that is not covered by the guarantee margin that has been provided.
• They are “Over The Counter” (OTC) products. In other words: They are not traded on organized or regulated markets. They are issued by a market maker, who in turn provides the price.
• Liquidity is not always the same in CFDs. Therefore, it is possible that in some cases there is no counterparty for the operation.
• When buying a CFD, we are not buying a stock. The CFD only replicates the price of an asset. Thus, we do not have the same rights as a shareholder, such as attendance at Meetings and voting.

With all this information about what CFDs are on the stock market, we can get an idea of ​​what it means to operate with them. It is clear that they offer certain advantages, but we must also take into account the drawbacks so as not to be surprised. We can always consult the Key Information Document for the investor before performing an operation on a product. This way we can know its characteristics and its level of risk in advance.