What is CFD

CFD Trading Explained

The basics

What is CFD trading? In a nutshell, CFD trading is similar to any other transaction that takes place on the investment market. The core difference lies in the absence of ownership. When you enter a CFD contract, you agree to speculate on the price changes of an asset without holding the actual asset, be it a share, an index or a commodity. You simply trade the difference in asset’s price.

Easy access, transparency and low costs appeal to investors, and that makes CFD trading very popular no matter what level of success you’ve achieved. Contracts for difference are affordable, and they let you try every asset class. You can switch between them easily. For instance, if trader believes the market is going to fall, they usually sell CFDs on market indices. When the equity market is doing great, they enter CFD trading on shares.

To illustrate how it works, let’s take a look at a CFD example:

Typically, you enter a CFD agreement with the help of a broker, in other words a CFD provider, be it an investment firm, a trading app, or other. As with any other type of trading, CFD trading involves risks. It is a leveraged product, which basically means you borrow money from another party.

Why CFDs?

The principal advantage of a CFD contract is that it enables you to gain access to most of the world’s markets with just a 10% margin, and sometimes even less. The concept is very close to borrowing, but CFDs are a way smarter. They give you the chance to make a profit. Yet, you may end up bust.

Other reasons include:

 
Speculation
People trade CFDs to gain on price movements in the short-term. It is often called ‘swing trading’ and it tends to happen on both bullish and bearish markets, where buying and selling opportunities are literally everywhere. Such trades are obvious. They are easy to identify. You don’t need expensive research or deep market analysis. The tricky thing is that it is sometimes very hard to specify the exact date or even moment when this period of price adjustment is going to end.
 
Hedging
Some traders consider CFDs a good risk management strategy to protect themselves in times of market uncertainty and also when they suspect that the shares they are holding are going to sink in value.
 
Short-selling
You can benefit from a falling market. If you open a short trade when a position is dramatically losing in value, you can gain on the dip in price.
 
Low cost
CFD trading is often labelled ‘the cheapest’ type of trading. But, it is not for nothing. The cost doesn’t usually exceed 10% from the value of the deal in the form of spread or commission.
 
Dividends
Yes, entering a CFD contract on shares can reveal an easy path to a company’s dividends. If you hold over a period of time before it goes ex-dividend, you have the right to claim the exact amount of dividends that an ordinary shares ensures.

Spread and commission

A typical CFD contract is quoted in the buy price (offer/ask price) and the sell price (bid price). Sell prices are always lower, whereas buy prices are a bit higher. The difference between them is often called the spread.

Some brokers charge traders commission for trading on their trading platforms. The amounts vary, but, overall, it’s considered cheap. Often CFD trading is referred to as low-cost trading. Most brokers charge commission from 0,1%. In other words, if you had a CFD trade with a total position of $10,000, then the brokerage fee will be 0,1% on the sum, or $10.

Commission on shares is usually calculated by a separate pattern and it depends on the region.

Size

The contract size of a CFD depends on the underlying asset. For example, a share CFD implies 1 share. So, if you intend to trade 1000 shares of XYZ using contracts for difference, you should buy 1000 CFDs. Commodities are far more interesting from this perspective. The contract size of gold is a troy ounce. Soybean is traded in bushels. Coffee is traded in pounds, and so on.

Going long with CFDs

When you buy a CFD in order to take advantage of the situation when a share increases in price, you go long and expect that the market will skyrocket. Let’s take a look at how it works.

Assume that now Apple stocks are trading at $160. We intend to purchase 100 shares, so the total price will be $16,000. In a few weeks price will have appreciated to $170. The gain is $1000 ($16,000 to $17,000). You win. But! The forecasts are not always that accurate. Predictions can be wrong. If the price moves in the opposite direction, we will suffer losses.

Why are stop losses good for you?

To create a safety net for yourself, it’s better to use stop loss orders. In fact, use them as often as you can. Don’t forget that when you trade on leverage, it’s not always rainbows. Loss is always possible. Even if you are told that the deal will end in a 100% profit, it may not.

Of course, most brokers monitor your balance with margin calls. But honestly, what if you simply don’t pay attention to all these notifications? What if you don’t have time to fund your trading account before it’s too late? What if you religiously believe in your luck and don’t read the notifications on purpose?

Setting stop losses is an extremely good practice for any trader, even for a seasoned one (and that’s not speaking of beginners). You may question the importance of stop losses when you don’t have open positions and currently are not involved with any deals. But, once you feel the emotional weight of a falling market, you will understand how painful it is to lose your own money in a matter of seconds. The market is volatile, and you should accept that, it will help make you a smarter trader.

The good news is that today most CFD providers don't let your balance go below zero. If you don't have enough capital on your trading account, you get margin calls. If they don't drive your reaction or you ignore them, your funds will continue to drop. If you don't do anything, a broker closes out your account. That's it.

Going short with CFD

Let’s take a look from the other perspective.

Consequently, long CFDs are a perfect strategy in bullish markets, whereas short CFDs are good for bearish markets.

Duration

One of the major points of CFDs is that they do not have an expiration date (in fact, a lot of other derivatives products like options have). A trade is closed only when placed in the opposite direction (that opened it). As simple as that. For example, you can close a buy trade on 100 CFDs on silver only by selling these CFDs.

Furthermore, you don’t have to worry about delivery.

If you don’t close your position during a trading day, you have to pay an overnight fee for keeping it open.

Profit and loss

Profit and loss are easily calculated with a simple formula. You just multiply the number of contracts you hold by the difference in prices (when you entered CFD and when you closed it).

To make the calculation as accurate as possible, you should remove any extra costs like overnight fees or charges.

Profit/loss = number of CFDs x (closing price – opening price)

Take that you purchase 1000 CFDs of XYZ when they were trading at 400p per share. Assume you sell XYZ shares when they are trading at 450p per share.

Profit/loss = 1000 x (450 – 400) = 50,000p

Your profit is £500.

How to nail CFD trading?

‘CFD trading explained’ theory is good, but practice is far better. Learn how to trade contracts for difference with Capital.com, a smart trading platform that introduces you to the largest world's markets, including blue-chip companies, popular commodities and major market indices.

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