CFD trading means buying and selling Contracts for Difference (CFDs). CFDs are derivative products that allow you to trade markets such as stocks, forex, indices, and commodities without physically buying or selling stocks, currencies, or futures.
With CFD trading, you agree to exchange the difference in the value of an underlying asset from when the contract is opened until it is closed. One of the main advantages of CFD trading is that you can speculate on price fluctuations in both directions, with the profit or loss you make depending on how accurate your forecast is.
What is CFD trading, and how does it work
CFD trading makes it possible to speculate on rising and falling prices. A CFD position is, therefore, helpful in replicating a traditional investment and generating profits when the price of an underlying market falls. This is called “going short” instead of “going long.”
If you think the Apple price will fall, you could sell the relevant share CFD. Again, it’s the difference in value between the opening and closing prices, but you would make a profit if the stock price falls and a loss if it rises. Whether long or short, profits and losses are only realized after closing the position.
Leveraged CFD trading explained
Leveraged trading with CFDs makes it possible to move a higher position value than conventional trading. Suppose you want to open a position in Apple with 500 shares. A traditional investment would pay the total share price. With CFDs, on the other hand, you would only have to deposit 20% as a margin.
With leverage trading, you agree to exchange the price difference for a higher equivalent of the underlying asset without having to put down the total outlay upfront. However, the profit and loss are calculated based on the total position size, in this case, 500 Apple shares.
This means that profits and losses can be hugely multiplied compared to your original investments, and losses can exceed the entry margin. Because of this, it is important to pay attention to leverage and ensure you are trading within your means.
How does CFD margin work?
Leverage trading is sometimes referred to as “trading on margin” because the funds required to open and maintain a position – the “margin” – is only a fraction of the total size of the trade.
There are two types of margin when it comes to margin: initial margin, which is the individual margin required to open a position, and variation (or aggregated) margin, which would be required if your trade is about to lose, which is the initial margin and will not cover any additional funds in your account.
If a leveraged position performs adversely, your broker may receive a margin call asking you to margin your account. If you do not raise enough funds, the position may be closed, and any losses incurred will be realized.
Hedging with CFDs explained
CFDs can also be used to hedge against losses in an existing portfolio. If you think that one of the investments in your account could fall in value, you can offset potential losses by selling CFDs short. Let’s say you own shares worth $1,000. By entering into a short CFD position of the same value, you could offset potential losses due to a fall in the value of the underlying market with the ongoing profit of your short CFD trade.
Important concepts of CFD trading
Here we explain four of the most important concepts of CFD trading: spreads, trade sizes, holding periods, and profit/loss.
CFD prices are quoted in two notations (bi-directional prices): the asking price and the buy price. The sell (or bid) price is the price at which you can open a short CFD. The purchase price (or ask price) is the price at which you can open a long CFD.
Selling prices will always be slightly below the current market price, and buying prices will always be slightly higher. The difference between the two rates is called the spread.
CFD trading spread and commission
In most cases, the cost of opening a CFD position is covered by the spread, which means that the buy and sell prices are adjusted to the cost of closing the trade.
Exceptions to this are share CFDs, which are not settled via the spread. Instead, the buy and sell prices match the price of the underlying market, and the fee for opening a CFD share position is commission-based. Using commissions, speculating on stock prices using contracts for difference is closer to buying and selling physical stocks.
CFDs are traded in lots, standardized contracts. The value of a contract depends on the underlying asset and often corresponds to the size in which it is traded on the market.
For example, silver is traded at 5,000 troy ounces per lot on commodity exchanges. Accordingly, a silver CFD is traded for 5,000 troy ounces per contract. In the case of share CFDs, one contract usually corresponds to one share. So you would buy 500 CFD contracts of one Volkswagen share to reflect a purchase of 500 Volkswagen shares.
CFD trading is often closer to traditional trading than other derivatives, such as options.
CFD trades do not have a fixed expiration date, which is another way CFDs differ from options. They are closed by placing a trade in the opposite direction to that chosen when opening. If you bought 500 gold contracts, you must sell 500 gold contracts to close the position.
If you leave a CFD position open at the end of a trading day (around 11 pm) you pay financing costs for holding it overnight. This fee reflects the cost of the capital that we ended up lending you to open the leveraged position.
However, this is only sometimes the case. Forward contracts are exempt from these costs. A forward contract expires at a specified time in the future, and all financing fees are factored into the spread.
Win and loss
To calculate the profit or loss of a CFD trade, one first multiplies the number of contracts by the value per contract (“per point” movement). This sum is multiplied by the difference in points between the opening price and the closing price of the position.