What is CFD in trading and how does it work?
Here’s everything you need to know.
For any person who would like to involve themselves with investments and into the world of trading, it may seem intense to try to even dip your toes into it because of all the jargon that one has to know. We want to start explaining CFD trading with this article and guide you to a much simpler process in understanding how this all works and where to begin.
What Is a CFD (Contract for Difference)?
While stock is an asset type or class, a CFD is an instrument or a derivative.
A contract for difference, or a CFD, is a financial contract between you (as an investor) and a CFD provider. Within it, it is agreed upon to settle the difference between an opening price and a closing price of a particular asset (such as a stock) that you have taken a position on once it is closed.
This means that it gives you a chance to be an active and engaged trader regardless of the market conditions. You can trade with a wide variety of popular financial markets, such as stocks, indices, commodities, bonds, precious metals, and forex, without owning the underlying asset.
How Does a CFD Work?
CFDs are traded on what is known as a “margin’, and therefore, the entirety of the process of buying a CFD is called “trading on margin.
What this all just means is that when you buy a CFD, you don’t have to pay for the full value of a position or put up the entire cost of a trade as is done with a stock investment. All that is needed is merely a fractional amount of the trade as collateral. The basis of the amount is defined by the requirements set by your CFD provider.
For example, let us go back to Company X mentioned prior.
Buying 100 stocks would cost you 1000 USD.
However, let us say you were to buy 100 CFDs at 10 USD with a margin of 5%. This would mean that the expenditure of such a transaction would only be 50 USD instead of the 1000 USD if it were purchased as a stock.
Put simply, an increase in the price would bring about 20 times more return on the investment capital. On the other hand, it can also mean that potential losses are just as dramatic.
How Do You Make a Profit with a CFD?
As initially stated, CFDs allow you to trade on the price movements of financial markets such as stocks without actually owning them. Therefore, you take a position based on whether you think the asset will go up or down in value. The profit you make is the difference between the price when you entered your position and the price when you close it. The profit is dependent on whether the market moves in your anticipated direction.
This means that you can profit from both rising and falling situations. If you expect the market price of an underlying asset to go up, then you can buy a CFD to benefit from that rise, and your profits rise in line with that increase. This is known as “going long.”
So let’s say Company X mentioned earlier was bought at 100 CFDs for 10 USD and is now selling at 15 USD. Your 100 CFDs x 15 USD is now equal to 1500 USD.
1500 USD – 1000 USD = 500 USD. Meaning you made a 500 USD profit out of your position while only investing 50 USD.
“Going Long,” in essence, is like buying traditional stocks.
Conversely, the reverse of “going long” is “going short”, which CFDs can also be sold at. Therefore, if you think an underlying asset will plummet, you can still make a profit if the market falls by initiating a trade by selling the CFD and then buying it back at a lower price. The profit is made between the sell and buy prices.
However, it is important to keep in mind that while your profits are amplified with CFDs, any opposing movement to your position can result in losses that are just as magnified.
Features of a CFD
Trading CFDs with an experienced broker is a simple process. But to get you started, please note the following characteristics.
The main feature of a CFD is known as “leverage” and is one of the main benefits of CFD trading. Leverage is being able to trade nominal amounts but opens up a larger position. It is the reason why you can have huge profits out of initial deposits. In reverse, it can also be a double-edged sword and the reason that you can get losses that exceed your initial deposit. It is really up to you how you are able to manage your capital effectively and how you are able to work during a certain timeframe.
Consequently, CFDs are ideal for active short-term or intraday trading as it is based on profiting from up or down price movements that occur from hour to hour or minute to minute.
Going Long and Going Short
As explained earlier, one of the main benefits of purchasing CFDs is that you can benefit from both rising and falling markets.
With CFDs, you can diversify your market exposure by trading on a variety of assets in a wide range of global markets with limited capital and all from one account.
Low Transaction Costs
When you want to buy stocks, you may lose money due to currency movements and currency conversion costs. In other words, if your account is in euros and you want to buy a stock such as Apple that is priced in dollars, amounts will be affected from your trading platform converting your euros into dollars. But with CFDs, you do not need to convert your euros to dollars, so long as you have enough money in your account as margin for any commission or potential losses to be covered. Profit, losses, and commission will have to be converted into your specific account currency.
It is important to note that other costs are automatically included in the bid-ask spread for some types of CFDs. Financing or borrowing costs can also be associated with CFDs if you borrow stock in order to short single stock CFDs.
CFDs allow trading around the clock; in other words, it is available 24/7. Trading executions are also fast and automated regardless of the price and time, therefore also reducing the risk of an overnight position.