CFD trading, short for Contract for Difference trading, is a popular financial instrument that gives traders an opportunity to speculate on the price movements of different assets without having to own them. It offers flexibility and the potential for profit in rising and falling markets. In this article, we will delve into the world of CFD trading, exploring its mechanics, benefits, and risks. Understanding how CFD trading works enables you to make informed decisions and navigate this dynamic market effectively.
What is a Contract For Difference (CFD)?
CFD stands for Contract For Difference. These financial contracts allow traders to gain exposure to price changes between start and end trade for assets they trade (going long) or short (going short), giving them an edge in speculating on an asset’s direction in any direction. They’re typically formed between traders and forex brokers and typically last only days or weeks unlike traditional investments which involve longer-term commitment.
CFD (Contract for Difference) traders tend to focus on forex (foreign exchange) and commodities. When trading CFDs, investors don’t actually own the asset being traded such as stocks, currencies or commodities – instead they gain exposure to any price movements of those assets through CFD trading. You can check the monetary values of these price movements and the possible outcome of your trade using trading calculators.
When the contract ends, the parties involved exchange the difference between the starting and ending prices of the financial instrument being traded.
What’s the Appeal of CFDs?
CFDs allow traders to speculate whether an asset’s price will go up or down; depending on whether their prediction is correct or incorrect, traders could make either a profit or incur losses.
CFD trading involves two strategies, long and short positions – each can yield either gains or losses.
Traders who expect that an asset’s price will increase can purchase CFDs (known as going long). Conversely, those who forecast that its price will decrease can sell these contracts (known as going short).
Unlike traditional trading, where you can only buy currencies and hope their value rises (going long), CFD trading offers the flexibility to sell assets you believe will decrease in value.
Going short in CFD trading follows a similar principle to going long. Instead of purchasing contracts to open a position, you sell them.
By doing so, you initiate a trade that generates profit if the asset’s market value falls but incurs a loss if the market value goes up.
In the CFD market, you will encounter two prices: the buy price (ask price) and the sell price (bid price). When you open a long position, you execute the trade at the buy price, while going short involves trading at the sell price.
To close the contract, you reverse the action you took when opening it.
How Does CFD Trading Work?
Forex CFD trading enables investors to trade units of a financial instrument linked to an underlying asset without owning it. Companies that offer CFDs, like brokerages, provide access to various global markets such as currency pairs, stock indices, commodities, and shares.
In CFD trading, traders don’t decide on the quantity of the asset they want to buy. Instead, they choose the number of contracts they wish to buy or sell on their trading platforms. For CFD trading, most traders prefer MT5, as it has more indicators and time frames compared to other platforms.
If the market moves in the trader’s favour, their position will earn a profit. However, they will face a loss if the market moves against them. Profits or losses are realised when the trader closes their position by selling the contracts they initially bought.
Similar to traditional trading, the return on trade depends on the size of the trader’s position and the number of points the market has moved.
What’s the Risk With CFD Trading?
CFD trading involves a certain level of risk. CFDs are considered “leveraged” products, meaning traders only need to deposit a small percentage of the total trade value to open a position. This is known as “trading on margin” or “margin requirement”.
This setup allows traders to open a larger position with a smaller margin. It has the potential to amplify profits. However, it’s important to note that this mechanism works in both directions. This means losses can be similarly magnified if the market moves against the trader. Therefore, risk management becomes essential in CFD trading.
More on margins
Margin in CFD trading refers to the funds required by traders in order to open and sustain leveraged positions with leverage, often expressed as a percentage of total trade size; its exact requirements depend on which markets a trader chooses to trade on.
CFD traders wishing to open forex positions typically need 5% of the total value in their account as margin. When opening CFD positions however, an amount that typically ranges between 25%-33% of trade size must also be set aside as margin.
Knowing the margin requirements in different markets is critical for traders as this determines the amount of capital required in their trading account in order to open and sustain positions.
What Determines Returns?
In Forex CFD trading, you don’t buy a specific amount of currency. Instead, you choose how many contracts to buy or sell.
If the Forex market moves in your favour, your position will make a profit. However, if the market moves against your prediction, you’ll experience a loss. Your profits or losses become real when you close your position and sell the contracts you initially purchased.
Your profit in Forex CFD trading depends on your position size and the number of pips the asset has moved in the direction you anticipated.
What are CFDs Used for?
CFDs in Forex trading offer traders the ability to engage in short selling, which can be used as insurance to offset or hedge potential losses in physical currency portfolios.
For instance, a trader holds £5,000 worth of a particular currency and has concerns about an upcoming decline in its value. In this situation, they could consider short-selling £5,000 worth of Forex CFDs related to that currency to help protect their portfolio.
When currency values drop 5% on the Forex market, traders who hold physical portfolios could offset any loss by placing short trades that offset it, providing safe harbor without incurring expenses and inconvenience from liquidating existing positions.
What Are the Costs of CFD Trading?
Forex CFD trading involves several charges that traders should be aware of. Since there are no trading costs on a demo account, traders must consider them before trading them on a live account. However, it is imperative that you evaluate your trading costs to make better profits.
The first cost is the spread, which refers to the difference between the “bid” and “ask” prices. It means a trade needs to move in a specific positive direction before a trader can sell it back at the original purchase price. While spreads are generally small, comparing them among different brokers is essential.
Some trading platforms claim to have no commissions. However, they may compensate for this by widening the spreads. Therefore, it’s crucial to consider the overall fee structure before selecting a provider.
Commission charges are also common, usually calculated as a fraction of a percent based on the value of the underlying security when a position is traded. However, separate commissions may not be applied for trading indices instead of individual securities.
Additionally, holding a CFD position overnight typically incurs a daily interest charge determined by a pre-agreed interest rate. Traders taking short positions may even receive interest on the trade value.
The interest rates for going long or short are outlined in the account’s terms & conditions, clarifying the associated charges.
Summary
In conclusion, CFD trading presents an accessible and versatile opportunity for traders to engage in the global financial markets. With its unique features, such as leverage, short selling, and a wide range of tradable assets, CFDs offer potential rewards as well as risks. It is crucial to conduct thorough research, develop a sound trading strategy, and manage risk effectively. By continually expanding your knowledge and staying updated with market trends, you can confidently navigate the world of CFD trading and strive for success in your financial endeavours.
