Contract of Difference

CFD is an abbreviation for contract for difference.

Contracts for difference (CFDs) enable you to speculate on over the counter (OTC) markets in underlying financial assets (instruments) such as shares, indices, commodities, currencies, and treasuries.

A CFD is called a financial derivative whose value is based on the underlying financial asset and that allows a trader to profit from price movements rather than owning the underlying asset.

Rather than buying a specific asset, the trader can speculate on how the price of that asset might change.

By entering into an agreement with a CFD broker, you agree to exchange the difference in the price of an underlying asset from the opening of a trade up to its closing.

Put differently, after opening a trade at a specific price, you wait for the price to increase or decrease, and eventually, earn a profit or suffer a loss on the difference in the value of the asset at the time the contract is closed.

The profit or loss you make depends on the extent to which your forecast is correct.

How does CFD trading work?

Simply put, trading CFDs gives a trader the opportunity to profit if a market moves up or down.

Trading in CFDs is a flexible alternative to traditional trading, giving a trader the flexibility to trade on the price of an asset, rather than buying the asset itself.

By not owning the underlying asset, you can profit from underlying markets rising in price as well as those falling in price. Put differently, as a CFD trader, you can trade when markets are rising or falling, twenty-four hours a day.

With CFDs, traders are allowed to trade from one trading account on the prices of different underlying assets, like shares, currencies, indices, and commodities like oil or gold.

Each CFD has a buy price (ask or offer price) and sell price (bid price), based on the price of the underlying asset.

If your expectation is that the price of the underlying asset will rise, you buy. This is called “going long” (also referred to as “a long trade” or a “long position”), meaning buying a CFD to sell at a later stage.

For example: Let us say the current market price of gold is $1 600 an ounce and you anticipate it may increase. You open the trade (buy) at the current price of $1 600 an ounce and close the trade (sell) when the gold price hits $1 620 an ounce. Your profit will be $20.

Going short” (also called a “short position” or “short trade”) implies selling a CFD to buy back at a later stage, if you think the underlying asset’s price will fall.

For instance: You open a short trade (sell) when gold’s current market price is $1 600 an ounce and close the trade (buy) at $1 540 an ounce, making a profit of $60.

CFDs follow the price of the underlying market. The more the market moves in the direction you predict, the bigger your profit. The more it moves in the opposite direction, the bigger your losses.

CFD trading also entails concepts like leverage, margin, hedging, and spread.

CFD leverage

CFD trading is leveraged, which means you gain access to a larger portion of the market without having to commit the full cost needed to open a trade.

For example: If you have $2 000 available in your CFD trading account and is allowed leverage of 50:1 by your CDF broker, you can access $50 for every $1 in your trading account. Put in other words, you are allowed to trade up to $100 000.

The implication is that, with a relatively small deposit, you can still make the same profits you would make in traditional investing, with the difference that the return on your initial investment is much higher.

However, the risk is that potential losses are magnified to the same extent as potential profits.

Keep in mind that your profit or loss will be calculated on the full size of your position, meaning the difference in the price of the underlying asset will be calculated from the point you opened the trade to the point you closed it.

The consequence is that both profits and losses can significantly increase compared to your initial investment and that losses can exceed deposits. Therefore, your leverage ratio is particularly important, and be careful to trade within your funds available.

Margin

There are two types of margin in CFD trading:

A deposit margin

Is the amount required to open a trading position.

A maintenance margin

Is the margin that may be required if there is a possibility that your deposit margin, and any additional funds in your trading account, will not cover potential losses. If this occurs, your CFD broker may call you, requesting you to top up your trading account. By not having sufficient funds in your trading account, your trading position may be closed, and any losses suffered will be realised.

Hedging

CFDs can also be used to hedge against losses in another existing portfolio.

For example, you hold a number of shares in company XYZ Limited in your current portfolio but expect these shares to fall in value in the future. By utilizing a short position through a CFD trade, you could neutralize some of the potential loss. Any dip in the value of the XYZ Limited shares would be offset by a gain in your short CFD trade.

Spread

In CFD trading, spread refers to the difference between the buy price and the sell price.

The buying price will always be higher than the current market price, and the selling price will be lower. The underlying market price will generally be in the middle of these two prices.

The cost to open a CFD position is most of the time covered in the spread. This implies that buy and sell prices will be adjusted to reflect the cost of making the trade.

Calculation of profits or losses from CFD trades

Multiply the total number of contracts by the value of each contract and then you multiply the first answer by the difference in points between the closing price and opening price of the contract.

Thus,

Profit or loss

=

(no. of contracts x value of each contract)

x (closing price – opening price)

To get the full picture, spread costs must be factored in, as well as other applicable fees or charges.

Advantages of CFD trading

CFDs:

  • Do not expire.
  • It can be used as a hedging strategy.
  • Enable a trader to trade on both rising and falling markets.
  • Grant traders the ability to go both long and short on underlying assets.
  • Offer a wide range of markets. A trader can enter various markets, like commodities, currencies, shares and indices from the same trading platform.
  • Provide higher leverage. CFD brokers typically offer CFDs with higher leverage than other traditional financial instruments.
  • Spare traders from many of the costs of traditional trading.

Disadvantages of CFD trading

  • Costs of spreads.

CFD traders are required to pay the spread on opening and closing positions. The result is that it is potentially harder to create small profits.

  • Trading CFDs can be risky and should not be traded without an exhaustive strategy for risk management.

CFD brokers and platforms

To start your CFD trading, it is important to choose the right broker who can offer you a reliable online CFD trading platform.

You should look for a broker who is regulated, licenced, secure, and experienced, and one you can trust.

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