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What is CFD Trading?

Contracts for Difference, more commonly known as CFDs, are trading products that are ideal for speculating on financial markets. CFD trading caters more to experienced traders as understanding what they are and how they work may be confusing for beginners.

However, in making use of intricate guides and tutorials, any trader can start exploring this dynamic form of trading.

It is important to understand that CFDs, like any other financial instrument, are complex and are associated with high risks of losing capital rapidly due to using leverage. There are between 74-89% of retail investor accounts which lose money when trading CFDs.

It is therefore imperative that traders educate themselves adequately and that they can mitigate the risks that they are exposed to before trading CFDs.

When trading CFDs, traders are provided with the opportunity to speculate on asset markets without having to physically purchase or sell the underlying asset. Traders can therefore profit from the future value of the asset, should they have speculated correctly, both if it increases or decreases.

This difference in value is more commonly known as a movement. Seeing that CFDs are derivative products, the value thereof is not causally linked to the underlying asset but origins from the value which is placed on it by both traders and brokers.

When traders choose to trade CFDs, they have a variety of assets from which they can choose including shares, indices, forex, and commodities. In more recent times, Bitcoin CFDs have also become more popular as contracts that are linked to cryptocurrencies.

Even though CFDs have become popular, they are still unavailable in numerous countries, especially the United States. As a result of this, the most popular market for CFDs can be found in Europe.

 

How does CFD trading work?

One of the simplest ways in which to explain how CFD trading works, is through the provision of an example. For instance, Asset A has a value of €40 per unit and the trader wants to buy 50 units. The cost of the purchase will therefore be €2,000 for the asset, and another amount for fees as well as commissions.

To complete such a trade, the trader is required to put up €1,000 in cash with a broker who provides the trader with a 50% margin. However, a CFD broker, on the other hand, would require a margin of 5%, or €100.

When trading CFDs, the trader will also need to pay the spread that the broker charges. The spread is the difference in price between buying and selling. The contract will be purchased with the buying price and the trade will be exited using the selling price. The smaller the spread charged; the smaller movement is needed in the favor of the trader for profit to be made.

When taking this information into consideration with the example, after the trader has purchased the asset, its value increases by €0.50, to €40.50 per unit. In a normal trade, the trader would be able to sell the asset and make a profit of 2.5%, excluding any other fees.

However, depending on the exchange, the CFD price may not reach the same value. For the example used, when assuming that the value of the CFD only rose by €0.40, the profit of the trade would total €20, which translates to 20% profit as a result of the more favorable margin.

Another consideration when trading CFDs is that there are no additional fees or commissions deducted from profits as with other forms of trading. Thus, even though the spread may be higher with a CFD broker than a normal market broker, profits tend to be greater than when traders buy the underlying asset.

When in reverse, however, should the trader’s speculation be incorrect, they risk losing more than they would have in a conventional trade.

 

Useful CFD Terms and Definitions

To fully understand CFD trading, one of the first steps that traders must take is to understand the jargon associated with it. All industries have their own language, even cryptocurrency, and understanding common terms, traders can begin to understand CFD trading more efficiently.

 

Contract Value

This is the full purchasing cost of the underlying asset of the contract. For instance, a contract consisting of 500 units of Asset A would have a contract value that is five hundred times a single unit price of Asset A.

 

Demo Account

This is a risk-free trading account that provides traders with virtual funds to practice trading CFDs. Demo accounts are offered by most CFD brokers and can help traders get a hands-on feel for trading CFDs in a mimicked live trading environment.

 

Leverage Margin

This is an example of margin trading where the trader borrows an amount of capital from the broker to open larger positions than the trader would have been able to. The larger the leverage, the higher the multiple which can be borrowed.

However, great care must be taken when using leverage as it can lead to great profits, but it can also expose traders to a substantial amount of risk.

 

Limit Orders

These are trading tools that allow for automatic trades based on buying and selling prices which have been pre-set. Tools such as these allow traders to enter and/or exit the market at a more favorable return than the value of the current market, this without the trading having to continuously monitor the price.

 

Loss

A loss is experienced by a trader should the contract’s value move in the opposite direction, going against the speculation of the trader.

 

Rollover

When traders roll their investment or trade over, it means that they extend their position beyond the expiry period, which is normally at the end of the day. Traders must, however, understand that there are often specific conditions that can incur additional fees.

 

Slippage

When the financial markets are experiencing high volatility, traders may not be able to execute buy or sell exactly as per their instructions as result of erratic price movements. This could lead to slight variations in the prices.

 

Spread

This is the difference between the bid and the asking price of a specific asset.

 

Stop-loss Order

This is a crucial risk management tool that protects both traders and brokers from substantial losses. The stop-loss order remains active until the order is either deactivated or the position is closed.

 

Underlying Market

This is the futures or the exchange price on which the trader’s CFD quote is based.

 

What are the advantages of trading CFDs?

There are several advantages associated with trading CFDs apart from traders being saved from the hassle of safely storing a physical asset. This is not great trouble when trading forex but when trading oil or gold, there may be some logistical challenges.

 

Short a stock with great ease

While ‘shorting’ is forbidden in a variety of markets or it may tie traders to certain conditions, trading CFDs allows traders to use shorting at any time at no extra cost. Since the trader does not physically own the underlying asset, they can short Bitcoin CFDs or any other applicable asset.

 

 

A small amount of capital needed to get started

Due to the access that traders have to high ratios of leverage, CFD trading can be done with exceptionally low margins which can often start at 3%. Lower margins mean that traders can start trading with smaller amounts of capital with the potential of earning great returns.

It should be noted that while profit potential is magnified, so are potential losses which can, in severe cases, deplete the trader’s trading account.

 

Access to a variety of markets

Primary CFD trading platforms allow traders to speculate across a variety of markets as well as asset while using one trading account.

 

What are the risks involved with CFD trading?

Traders have great opportunities for positive returns when they trade CFDs, however, due to the high risks involved, traders should never invest substantial portions of capital in such products. It is imperative that, before diving into CFD trading, traders understand the risks involved.

 

Counterparty Risks

This is associated with the provider of the contract which is being traded. Should the counterparty fail to meet the financial obligations placed on it with the trader or any other client, the value of the contract stands the risk of diminishing or even disappearing.

 

Substantial losses

CFD trading is an investment product that moves fast and experiences liquidity risks and margins that the trader must maintain. Should the value move against the trader and they cannot cover the difference, the provider may close the position, resulting in the trader losing the funds that they invested in that specific trade.

Since the trader does not physically own the asset, it will not matter if the value of the asset increases later. In addition, leverage is used in CFD trading and losses may exceed the initial capital of the trader. It is for this reason that traders are always urged to make use of Stop Limits.

 

Margin Top-Up

When a price movement experiences high volatility, the broker may require that the trader top up the capital that they invested so that the position can remain open. Should the trader not fulfill this requirement in time, the position may be closed, and the trader can experience associated losses as a result of this.

 

Price Discrepancies

CFD providers may charge prices which tend to be more expensive than the value of the asset when it is bought on an exchange.

 

CFD Trading Costs

Even though the costs associated with CFD trading are lower than with conventional trading products, they are still significant, and it is imperative that traders understand the exact costs of the broker before opening a position, allowing the trader to calculate the minimum price movement which is required for the trader to make a profit.

There are quite a few cost considerations that traders must understand before considering trading CFDs.

 

Commission

Commissions are charged whenever a trader either opens or closes a position. This is normally a percentage of the value of the trade. There are some platforms that may charge a minimum deposit that must be paid should the percentage not exceed this.

 

Spread

Whenever a CFD is bought, the trader must cover the spread cost. This is calculated as the difference between the asking and the bidding price. Larger spreads can often be found in markets that have low liquidity, which makes it difficult to get a return from a trade. It is for this reason that traders are advised to make sure of the liquidity of the market in which they wish to trade.

 

Holding Costs

These costs are comparable to loan interest rates. When traders borrow an amount from their broker to open a larger position, they are charged with holding costs based on the amount borrowed. These costs may increase daily for the duration that the position is kept open until the associated debt is repaid.

 

Market Data Fees

These are monthly fees to which traders are subjected to access price data, especially where international markets are concerned. This fee may vary between brokers and may even be completely waived for regular, active traders.

 

How to start trading CFDs

When traders have educated themselves in CFD trading, the next step involved in finding a CFD broker. It may seem like a daunting task, but when using the following points, traders can easily identify a broker that is suited to their trading needs.

  • Choose a regulated, reputable broker – CFD trading in its own is risky without adding the risk of a fraud broker. Traders must ensure that they use brokers who have the necessary regulation and who can safeguard client funds.
  • Have a look at customer support options – it is imperative that the broker offers a variety of channels through which traders can contact them with questions, queries, and any issues.
  • Withdrawals and deposits must be easy – even though some payment methods take a few days, traders should not experience difficulties with getting their funds back.
  • Platforms and markets must suit the trader’s needs – traders must know what they want from their broker. For this reason, traders are urged to use demo accounts until they can find the right combination of markets as well as features.

Author Details

Louis Schoeman

Louis Schoeman

Featured Forex and Stocks writer

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