A contract for differences (CFD) rewards parties for variations in settlement prices between open and closed transactions. CFDs allow investors to trade the direction of assets quickly particularly in Forex and commodities markets. In exchange for putting a small percentage of the contract’s notional payoff on the line, CFDs are cash-settled.
Rather of using a stock, currency, commodities, or futures market, this is done through a contract between the consumer and the broker. These advantages have fueled CFD trading’s meteoric rise in popularity over the last decade.
What is a CFD?
A CFD is a derivative product that allows you to speculate on financial markets such as shares, forex, indices, and commodities without having to take ownership of the underlying assets. CDF are also called as Contract for Difference. CFD trading is the buying and selling of CFDs where one agrees to exchange the price difference of an asset from the point at which the contract is open to when it is closed. CFD trading is more flexible as compared to traditional trading since it opens up access to foreign markets, leveraged trading, fractional shares, and short selling.
CFDs were initially used by institutional traders, portfolio management services and hedge fund managers as they provided a cost-effective hedge when trading stocks on the stock exchange.
Long and Short Positions
Since CFDs work on the prediction of price movements, investors can use them to take a position on both rising and falling markets.
- Buy (Entering and long position) – this is when you open a position where you expect an upward movement in price.
- Sell (Entering a short position) – this is where you open a position to sell at the market price with the intention of buying it back at a lower price.
This flexibility gives one the ability to profit whether the markets are going up or down.
Steps in Trading CFD
1. Choose a Market – the trader chooses an asset offered by the preferred broker. This could be a currency, index, stock or any asset in their selection. Fundamental and technical analysis undertaken will guide the trade to make an informed decision.
2. Decide to Buy or Sell – the trader will then open a position – CFD markets have two prices; Sell price which is the bid and buy price which is the offer. The difference between the two is referred to as the spread. The broker will quote their prices in the form of a spread. The bid-offer spread is also a representation of the demand and supply of the asset.
3. Select your trade size – 1 CFD is the equivalent of 1 physical share in equity trades. When trading indices, forex, commodities, bonds, or interest rates, the value of 1 CFD varies according to the instrument. Parameters are set whether it’s a long or short position, leverage, invested amount, and other parameters depending on the broker.
4. Add a stop loss – the position remains open until either the trader decides to close it or closed by a set command such as a stop loss, take profit point, or the expiration of the contract.
5. Close the trade – exit the trade. The broker pays the trader if the position closes at a profit. The broker charges for the difference, If it closes at a loss.
What is Leverage?
Leverage is a facility made available by the broker that allows a larger exposure to the market than the trader’s margin would allow. The trader puts down a fraction of the full value of the CFD and your broker loans you the rest. Leverage is usually calculated in multiples of the invested capital by the investors or traders. For example 2 times, 5 times, or higher. Any losses will be multiplied as well as profits.
Advantages of trading using CFDs
Higher Leverage – this enables the trader to have a much larger position on the market. This can magnify the returns, and ensure more efficient use of capital.
1. Global Market Access – depending on the broker, the trader will be able to trade in international markets, with round-the-clock access to various instruments such as cryptocurrencies, forex, indices, stocks, and metals.
2. Similarity to the underlying market – CFD trading is designed to follow closely the trading environment of the underlying asset. However, the positions will be adjusted to offset the effect of any dividend payment and the trader will not receive shareholder benefits.
3. No stamp duty – there is no stamp duty to be paid on a CFD trade as one does not have ownership of the underlying asset.
4. Trade in rising and falling markets – there are more trading opportunities available, as profits can be made from buying or selling CFDs on a wide range of financial instruments.
Disadvantages of Trading Using CFDs
2. Overnight positions – long trades held for extended periods of time attract interest payments. This may significantly reduce the returns.
3. Volatility – large spreads caused by volatility in the market will affect the prices paid on entering and exiting positions, increasing losses.
It is important for traders at all levels of skill to develop a disciplined trading strategy and trade with appropriate caution.
We are sorry that this post was not useful for you!
Let us improve this post!
Tell us how we can improve this post?