The abbreviation CFD stands for ‘Contract For Difference’, meaning that parties to the contract agree to pay the price difference of the underlying market. The underlying asset – a share, cryptocurrency or fiat currency pair, index, or commodity – acts as the basis for the contract. Since a CFD’s value derives from the price fluctuations of other financial markets, it is classified as a derivative.
How CFD trading works
The mechanism behind CFD trading is quite simple. The agreement takes place between a trader and a broker. Suppose the trader thinks that the value of a financial market will rise. They open a position to buy CFDs on this market, that is they ‘go long’ and if the price of the underlying asset increases, the trader profits. Similarly, if the trader predicts the asset value to drop, they sell CFDs, or ‘go short’.
However, if the trader predicts the market movement wrong, they have to bear the losses. The profit or loss equals the difference between the asset price at the beginning of the contract and its price at the end.
CFD trading: pros
A contract for difference is a leveraged financial instrument, which means you only need to deposit a percentage of the total trade value. This is referred to as the initial margin. The exposure of the deposited funds is then magnified, and the trader to bigger trades and potential profits.
Suppose your broker provides a 1:20 leverage for the chosen instrument. To be able to open a $20,000 position, you have to deposit only $1,000. In traditional trading, your investment equals your exposure.
In March this year, the European Securities and Markets Authority, or ESMA, introduced new leverage levels for retail CFD traders based on the volatility of the underlying asset. Capital.com became the first CFD broker to be totally compliant with the new restrictions. Our current leverage limits are as follows:
1:30 for major Forex pairs
1:20 for non-major Forex pairs, gold and major indices
1:10 for commodities except for gold and non-major equity indices
1:5 for individual equities and other reference values
1:2 for cryptocurrencies
A contract for difference is a more flexible financial instrument compared to conventional shares or commodities, etc. With CFDs, a falling market can become an excellent trading opportunity.
When you open a trading platform, you’ll see two buttons; ‘Buy’ and ‘Sell’. The latter means that you go short on a market, in other words you borrow it, sell it, and then buy it back to close the trade.
The key motivation behind short selling is the prediction that an asset’s price will drop, enabling to buy it back at a lower price to profit.