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:
David is an experienced investor with a profound knowledge of the markets. For many years he has been involved in trading. Amazed by the growing popularity of CFDs, he decided to give it a try. He believes that Gold will greatly rise price in a few weeks. The current quotes are $1200/$1205 (bid/ask – a $5 spread). David buys 100 CFDs on gold (takes a long position). The size of his position, or the contract value, is
100 x 1205 = 120,500
If the gold price goes up by $20 (as David hopes), the new quote will be $1220/$1225. In this case, David’s profit will equal to $1500.
100 x (1220 – 1205) = 1500
Yet, if the market takes the opposite direction, David will suffer a loss.
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.
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:
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.
For example, if the buy price is $55.12 and the sell price is $55.10, then the spread equals to $0.02. The spread is one of the cornerstone elements in the CFD trading. The smaller the spread is, the greater value you’ll receive from a trade.
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.
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.
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.
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.
Let’s take a look from the other perspective.
Assume that analysts say that Apple stock will fall in value dramatically, if not severely. As soon as we learn the news, we start to invent ways to gain from the price movement. The first decision that comes to our mind is to ‘short’ or open a selling CFD on 100 Apple shares at $160 each ($16,000 in total) and wait in expectation that the price will fall so we can buy the shares back at a lower price and benefit from it.
Consequently, long CFDs are a perfect strategy in bullish markets, whereas short CFDs are good for bearish markets.
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 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.
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