What is CFD trading? Contracts for Difference Explained
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The purpose of this article is to explain how contracts for difference (Or CFDs) work, and the terms associated with this type of trading. This article will provide a detailed explanation of CFDs, as well as, the main reason why people trade with CFDs, the risks associated with CFD trading, and more!
What Is A CFD?
CFD stands for 'Contract for Difference'. A CFD is basically an agreement to exchange the difference in the value of a particular asset, from the time the contract is opened, until the time at which it is closed. What is interesting to note is that with a CFD, you never really own the particular asset or instrument you have chosen to trade, but you can still benefit if the market moves in your direction. Technically, this is because a CFD is a so-called 'derivative product', meaning that it has a value primarily based on an underlying asset.
If you want to trade with CFDs, there are a lot of brokers that can accommodate you, and they have trading different platforms designed especially for CFD trading.
The Way CFD Trading Works
By trading with CFDs, you can potentially profit if a market moves either up or down. If you strongly believe that an asset's price is going to rise, you would then open a buy position, which is often referred to as 'going long'. Conversely, if you think that the asset's price is going to fall, then you would open a sell position, which is referred to as 'going short'. The actual performance of the market doesn't just govern whether you make profit/loss, but also how much.
For example, if you think a specific market will rise, you would purchase a CFD in order to trade it. Your profit will be considerably greater the further the market rises, and your losses will be greater the further it declines. The converse rule applies if you back a market to fail, so you will make more the further the market drops, and lose more the further the market rises.
It is no secret that with different brokers you can trade CFDs on a huge range of markets, incorporating indices, shares, Forex, commodities, and much more. For instance, trading a share CFD is in many ways quite similar to traditional share trading, but with extra advantages in terms of cost and convenience. You can also trade markets like stock indices through CFDs, which are not accessible to trade directly. You should take into consideration that CFDs are a leveraged product, and can result in losses that may surpass your initial deposit on your CFD trading account.
Let's take a look at the buy and sell price. We would like to exemplify a two way price on each market, in the same way that you would see in the underlying market. First of all, this encompasses the bid price (which is the first to be given) and the offer price (which is the second to be given). The difference between those prices is known as the spread. If you believe that a market is set to rise, you would buy at the offer (or higher) price, and if you believe the market is set to fall, you would sell at the bid (or lower) price.
How do you calculate profit and loss on your CFD account? It's actually very simple. The number of shares (or contracts in our case) you select to trade is completely up to you, as long as you meet the minimum size permitted for any specific market. You must remember that the value of one contract varies for different markets. For example, one contract for the FTSE 100 is worth £10 per each point of movement, in the underlying index.
Therefore, if you are going long on one contract on the FTSE 100, and the index rises by one point, that would result in a £10 profit for you. In the same manner, let's presume that one full contract of the EUR/USD currency pair is worth $10 per each point of movement in that FX pair. If you are going short on one contract on the EUR/USD currency pair, and the price rises by one point, it would end up as a $10 loss for you.
Most CFD trades do not expire. If you wish to close out a position, you would simply place a trade identical in value in the opposite direction. Let's use an example: Imagine that you have bought 100 shares of BP as a CFD. The price begins to fall so you decide that you would rather close the position before losing too much. In order to do that, you would sell 100 BP shares as a CFD. Of course, it is not always like that, and there are a lot of exceptions. Some brokers may offer forward contracts on different commodities, which expire at particular dates in the future.
Knowing that this is important will help you to better understand online CFD trading. That being said, you do not have to wait until the expiry date to be released from your forward contract - as you can trade out at any given time. There is no supplemental funding needed for forward contracts, because the value is priced into the spread.
What Are the Main Reasons for Trading CFDs?
CFD trading has plenty of brokers who are eager to provide you with a great deal of benefits, seemingly more than there are for other types of trading. Let's focus on the main advantages that can be enjoyed on CFD accounts. The first advantage that comes to mind is the Direct Market Access (DMA). Some providers offer DMA, allowing you to trade directly into the underlying order book of equity exchanges throughout the world.
With so many different brokers available, you have access to a wide range of markets, particularly shares, options, CFDs, commodities, and interest rates. Knowing that you never own the underlying market, you can trade on markets that would otherwise be untradeable, e.g. cash index products. The markets we have mentioned are the most popular and common markets where you can trade CFDs. However, the full list is vast, encompassing a growing number of ETFs and ETCs, not to mention the consequences of economic and political data releases.
The list of benefits is far from over. Traders are able to benefit from falling markets as well as rising ones when trading CFDs, unlike the majority of traditional forms of trading. Do not forget that you can usually gain access to low commission rates on the contract value for some share CFDs. If you prefer short-term trading, then we have good news for you. CFD is fully suited to short-term trading. As you can trade CFDs on margin, ahd you can capitalise on short-term market volatility, without having to put up a large starting investment.
CFD trading can be unlimited. That means that you can access trading opportunities 24/7, with different brokers. This is called 'round-the-clock trading', which means that you can even open and close positions when the underlying market is closed. Furthermore, trading with CFDs also means that there is no fixed time period involved. Whilst some markets may have expiry dates built into the trade, share CFDs do not. In turn, this implies that you can close your share CFD positions at any time you wish.
CFD trading can be executed extremely quickly, however, this does depend on the broker you use. Some brokers offer trading platforms where you can open and close positions in the blink of an eye. You should keep in mind that on a good platform, prices are live, and that different automated systems can handle most transactions immediately.
You can also use leverage when trading CFDs. This means you only have to put up a fraction of the value of a position to open each trade, permitting you to free up some of your capital for other important uses. You should remember that even though there is an actual purchase involved when trading contracts for difference, you still get exposure to the markets you are currently trading on.
What are the Risks of Trading CFDs?
The main risk with CFDs is market risk. If the market moves against you, the value of your position will reduce. This is no different to the risks you run with most traditional forms of trading. So once again to recap, what is CFD trading? CFDs are leveraged products, and this can substantially increase the risk of larger losses you may incur.
Trading CFDs can be a good money maker. That being said, as with all types of trading, you should ensure you have a good knowledge of the markets and all of its aspects to maximise the chances of profitability. Be aware of the risks involved, and make sure to implement risk management within your trading. If you would like to learn more about trading with CFDs, or related topics to CFDs, why not check out the following articles?:
This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.