What is CFD Trading?
- 1 Is CFD Trading Right for You?
- 2 How Does CFD Trading Work?
- 3 Let's Look at A CFD Trading on the US 500 Index
- 4 This Sounds A Little Like Spread Trading — Doesn't It?
- 5 CFD vs Spread
- 6 Summarizing About CFD Trading
CFD stands for Contract for Difference, essentially where you trade whether the price of a market will increase or decrease in the short term.
If you forecast correctly, your profits will be determined by the price difference between the opening and closing of the trade. This price movement also determines how much money you lose on unsuccessful trades.
CFD trading is popular because you don't really need to own what you're trading. For example, you can trade based on the movement of Apple stock prices without having to buy them.
There is less financial commitment in this regard, which obviously has its appeal. It also means that you have the option to trade and profit from markets that are falling in price as well as those that are rising.
However, the way CFD trading works means that overtrade is very easy and losses can be enormously magnified compared to the amount of money you need to open the trade.
Furthermore, you have no control over the currency you are trading in, which can result in additional costs and complications.
Is CFD Trading Right for You?
We assume you're here because you've heard about CFD trading and think it's the right way to start your life as a trader. Before getting into this subject, we want to make sure you know what it is.
Trading CFDs is certainly not simple and there is a lot of confusing terminology involved as well. This means that it is generally not the best way for traders to start their journey.
Things You Can Hear About CFD
"Long positions" and "short positions"
Going long means you are buying contracts because you believe prices will rise. Short positions are the opposite — selling them anticipating prices will fall.
Leverage refers to the fact that you don't have to pay the full trade amount to open your position.
You only need a small percentage in your account, which acts as a deposit. For example, you might be able to make a $1.000 CFD trade with just $200.
This may seem like a benefit, but leveraged products like CFDs can be very risky for this reason.
Keep in mind that profit and loss is based on the total trade amount (not the deposit), so they will be increased. Great if your prediction is correct and you make a profit, but if you get it wrong, you might be shocked at the size of your losses.
Margin is the amount of money needed to open a trade. For example, a 5% margin rate means you only need to put in 5% of the total amount.
Trading CFDs always requires a deposit margin, but you may also need to pay a holding margin if your losses exceed that margin.
How Does CFD Trading Work?
Each contract has a sell price and a buy price, which are respectively slightly lower and higher than the current market price.
The difference between the buy and sell prices is called the spread and reflects how much it will cost you to trade CFDs.
If you think market prices are going to go up, you buy a series of CFD contracts (also called units).
On the other hand, you sell these contracts if you think prices will fall. It is possible to trade CFDs on many financial markets like forex, commodities, stock indices and stocks.
There are no fixed expiry dates on CFD trades, therefore, to close your position, you must make a trade in the other direction. For example, if you bought 500 contracts, you would sell them.
It's also worth bearing in mind that you will have to pay interest every time you keep your trade open overnight. These fees can increase, which is why CFD trading is not suitable for long-term positions.
Let's Look at A CFD Trading on the US 500 Index
In this example, the CFD provider stated that 1 CFD is worth $1 per pip and one pip is equivalent to 1 point total of $500. If the $500 goes up by 1 point, you will make a profit of $1.
The buy and sell prices in the US 500 are 3.151.0 — 3.151.5. You believe prices are going to go up, so you buy (or trade long) 2 CFDs at 3.151.5.
The total value of your trade is calculated by multiplying the price you traded by the number of $ per pip you bought:
3151.2 x $2 = $6,302.40
There is a 5% margin fee for a trade in this market, 5% of $6.302,40 is $315,12, so that's all you need in your account to make the trade.
See how CFD trading can work.
- A WINNING CFD TRADING
You are correct and prices increase. You close your position when the US 500 quote is 3.223,4 — 3.223,9, selling 2 CFDs for 3.223,4.
Calculate the difference between opening and closing trades and then multiply by the number of CFDs to see your profit.
3.223,4 — 3.151,5 = 71,9 points
71,9 x 2 CFDs = $143,80
- A LOST CFD TRADING
Unfortunately the market has changed against you and you have to sell 2 CFDs to close your position.
Now the quote of US 500 is 3.102,2 — 3.102,9 and your loss is calculated like this:
49,3 x 2 CFDs = $98,60
3.151,5 — 3.102,2 = 49,3 points
This Sounds A Little Like Spread Trading — Doesn't It?
We have already mentioned that trading CFDs involves a spread, making it very similar to trading with a spread. Both types allow you to speculate on the financial markets, but spread trading is by far the most direct way to do this.
CFD vs Spread
With CFDs, the currency you trade depends on the specific market. If you normally use sterling but the trade you want to make is in US dollars, you will need to consider how this influences how much you can win or lose.
Currency exchanges will be involved, increasing your overall costs. Spread trading, on the other hand, lets you use your preferred currency so you always know where you are.
Spread trading also lets you choose the value per point, giving you full control over how much you're trading and making the numbers much easier to understand. However, with CFD trading, the value per point is decided by the provider.
For example, the provider could say that 1 CFD is worth $10 per pip, with a pip being worth 1 point total of $500, but it could also say that 0,1 of a point is a pip. This can lead to more confusion when trying to calculate potential profits and losses.
CFD Pros and Cons
- — CFDs allow investors to trade the movement of asset prices, including ETFs, stock indices and commodity futures.
- — CFDs provide investors with all the benefits and risks of owning a security without actually owning it.
- — CFDs use leverage which allows investors to place a small percentage of the trade value with a broker.
- — CFDs allow investors to easily take a long or short position, or a buy and sell position.
- — While leverage can amplify gains from CFDs, leverage can also amplify losses.
- — Extreme price volatility or fluctuations can lead to large spreads between a broker's buy (buy) and sell (sell) prices.
- — Investors holding a losing position may get a margin call from their broker, requiring the deposit of additional funds.
Summarizing About CFD Trading
Still feeling a little confused? Do not worry. As we said, trading CFDs can be very complicated, especially for new traders.
It can also be a lot more expensive than you probably think. We've already mentioned that you may need to convert any profits you make into the currency of your choice in order to actually withdraw them.
Guess what? Your provider will charge you a hefty premium for this. You are paying for your own money. We always recommend doing a broker comparison to see the best rates you can. see here.
Another thing to keep in mind is that the spread on CFD trades can move overnight. The spread determines how much it will cost you to trade and this can change daily, so you will never know for sure what your trading fees are.
This might sound a lot more expensive than expected. In addition, you often also have to pay a commission fee on CFDs. Despite all this, CFD trading is still an avenue you want to explore.
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