CFD definition: What is CFD and how a CFD works?

Contract for Difference - CFD definition

CFDs or Contracts for Difference have become a revolutionary tool for online trading. They make it much easier for traders to enter the stock, commodity, or index markets.

How can CFD be defined?

CFD is a derivative financial instrument that allows traders to take advantage of fluctuations in the value of the underlying asset. Investors can trade products in the same way as on the traditional market, using the standard principle of buying low and selling high, and then selling high and buying low. CFDs are a relatively simple way to trade numerous global financial instruments, including commodities, indices, stocks, and government bonds.

CFD: meaning and working scheme

CFD trading is a method that allows individuals to trade or invest in an asset by entering into an appropriate contract with a broker instead of directly purchasing such an asset. The trader and the broker agree to compensate each other for the difference between the real market price of the asset at the time of opening and its price at the time of closing the position. CFDs provide traders and investors with the opportunity to profit from price fluctuations in the financial markets without having to own the underlying instruments.

Markets to trade CFDs

CFDs are a great opportunity to make money on various assets. The contract for difference is a trading tool that can be used for both long-term and short-term investments. CFD transactions can be opened for minutes or years, which allows gaining on investments in the same way as on an exchange with real assets.

An important feature of the CFD is also the fact that, unlike the regular markets, the CFD market allows traders to gain on rising and falling prices. Overall, the most common assets for trading them via CFDs are the following:

  • Stocks
  • Indices
  • ETFs
  • Commodities
  • Cryptocurrencies
  • Precious metals

However, this list is not exhaustive, as there can be thousands of contract for differences in prices based on many other financial instruments. Each of the above-mentioned assets has its characteristics of trading through CFDs. For example, in stock trading, you traders are not paid dividends as they do not acquire the physical shares. Therefore, using dividend strategies in CFD trading is usually not possible.

CFD trading definition and features

Trading CFD means buying and selling contracts for difference, which are based on an underlying asset. CFDs are always traded through a financial service provider. That is why when choosing a broker, it is important to familiarize yourself with its trading conditions, the amount of leverage provided.

CFD trading has many nuances and peculiarities that affect them on the positive side for traders.

  • The use of leverage. This opens up opportunities for highly risky but possible ultra-profitable trading.
  • Wide diversification. CFDs make it possible to trade several thousand assets from different countries at once with one broke.
  • No restrictions on day trading and short positions.

Costs needed for CFD trading

The popularity of Contracts for Difference has grown dramatically over the past few years and, at the moment, they are arguably the most preferred way to trade in the financial markets. Since CFDs do not require the physical purchase of the traded asset, CFD trading allows traders to avoid costs in the direct purchase and delivery of products, the need to register them, and the responsibility for their storage and payment.

Oftentimes, the value of a CFD per share, futures or commodity is the same as the value of the underlying asset. Thus, a CFD is a more simplified way to trade, because investors can trade all the previously listed assets, but without buying them directly.

In addition, the purchase of assets can be a costly business not only in terms of finance but also time, while trading contracts for differences allows you to conduct transactions very quickly. Besides, another important advantage is the fact that the corresponding contract for difference can be used even when the underlying asset is not available for trading.

The cost of trading CFDs includes the commission charged by the broker, the funding cost if you buy the asset, and the spread, which is the difference between the bid and ask price at the time of the trade.

Leveraged CFD trading

CFD trading uses leverage that differs depending on the underlying asset and the chosen broker. Leverage is a great way to increase the amount of trade in order to gain more. When trading with leverage, the trader borrows from the broker for the duration of the transaction and returns upon completion of the transaction. At the same time, the trader completely retains the received profit, and this fact reflects one of the biggest advantages of leveraged CFD trading.

Concerning leverage size, it can be quite different and depends mostly on a financial service provider’s trading condition. The minimum leverage is usually 1:10, that is, a trader can increase the bet volume 10 times due to the broker's borrowed capital. The maximum leverage can reach 1: 500.

However, all traders should be careful with leverage, especially beginners. After all, if the deal is unsuccessful, then the loss on the deal will also be greater, so beginners should choose small leverage for the first time. However, if traders catch a good trend, then even with minimal leverage, they can manage to get a decent income.

 Gaining on both growing and falling markets

When traders believe the asset's price will rise, they go long or “buy” and they will take benefit from each price increase.

If traders think the price of an asset will fall, they go short or “sell” and gain from each fall in price. Of course, if the markets do not go in the direction traders expect, they can lose their funds. The size of traders' profit or loss depends on the size of their position (lot size) and the amount of movement in the market price.

The ability to go long or short, along with the fact that CFDs are a leveraged product, makes CFD trading one of the most flexible and popular ways to trade short-term movements in the financial markets today.

Hedging physical portfolio with CFD trading

CFD trading is also good for hedging the investor’s portfolio. For example, if traders have already invested in an existing portfolio of physical stocks with another broker and think that they may lose some of their value in the short term, they can hedge their physical stocks with CFDs. By short selling these stocks as CFDs, they can try to profit from a short-term downtrend to offset any losses from your existing portfolio.

Similarities and differences between CFD and Forex markets

The Forex and CFD market have many things in common and also they have specifics that differ from each other.

One of the obvious differences is that Forex trading refers exclusively to currency pairs trading. CFD trading includes various types of contracts, including CFDs on indices, commodities, stocks, and many other assets.

However, there are several similarities between Forex trading and CFDs. For example, traders in both markets never need to own the underlying asset for opening positions. Moreover, participants of both markets can use the same trading platform.

Rollover rates apply to both spot forex and CFDs, which are also known as “swap fees” in the forex market (also known as funding fees). It is the fee for holding an open position overnight and is tied to the interest rate of the base currency.

In addition to using leverage, the similarities between the CFD market and the Forex market lies in the ability to complete a transaction at any time. The traders have the opportunity not to wait for the expiration date when the CFD will be closed automatically, but to control the situation on their own. For example, traders understand that the trend for their market asset has reached its peak and there will be a reversal further, then they close the deal while the profit on it is greatest.

In CFD trading, just like in Forex, clients can use such options as taking profit and stop loss. Stop-loss for CFDs is the amount of the contract for difference itself, that is, even if traders used large leverage, and the transaction turned out to be unprofitable, they will still only lose the invested funds, but will not go into the red. Take profit is also a very important limiter, it allows traders to automatically close the contract when its profitability reaches the level they set. For example, if a trader has chosen a take profit of 150%, then as soon as the profitability of the deal reaches this level, the CFD contract will be closed.

Advantages of a Contract for Difference

Unlike in traditional trading, CFDs give investors more leverage, because the standard leverage in the CFD market has as low 2% margin requirement and could have as high as 20%. Lower margin requirements means that an investor needs less capital but could still have the same potential in gaining returns.

Another advantage is that the CFD market is not limited to minimum amounts of capital or numbers of trades in a singles session. An investor may open an account for as little as $1,000 for their capital.

Disadvantages of a Contracts for Differences

Since CFDs are not entirely regulated in the trade industry, a broker’s credibility is based solely upon his reputation rather than life span or financial position. And paying the differences in a trade prevents profiting in small contracts, while decreasing the chances of winning trades and increasing losses by a small amount over the underlying asset.

Conclusion

CFDs are financial derivative tools that allow traders to gain from the difference in the price of various assets. Such contracts are concluded with a broker and do not imply the ownership of the asset. There are thousands of variations of such contracts in different directions: from stocks to global and exotic stock indices, ETFs.

The key advantage of CFDs is their accessibility to a wide range of traders with small deposits. Trading CFDs means that clients can trade a portfolio of stocks, indices, or commodities without the need for a lot of capital. With the right broker with good trading conditions, traders cannot lose more funds than those that are available in their accounts. However, it is always significant to remember about potential risks associated with the use of leverage.

Overall, CFDs are prospective tools that perhaps will become more and more popular, as they open up access to many markets, and for these potential traders need to have only one single account with one broker. CFDs are an excellent portfolio diversification tool within your trading strategy, allowing you to take full advantage of our innovative platforms, designed to help you maximize your trading potential.

FAQs

How can I get started trading CFDs?

CFD trading is accessible only with a broker. So, to start trading CFDs, you should open an account with a financial services provider.

What does CFD mean?

CFD stands for Contract for difference, which means that this trading tool has the form of a contract on the difference between the prices of an asset.

How can I make money from CFD trading?

CFD trading can bring you income, when used with a proper strategy and is operated on a good broker’s conditions. You predict a price change, and if it turns out that you have made it correctly, then you gain.

How do I use CFDs for hedging?

CFDs can be used for hedging a physical portfolio by selling the assets as CFDs to gain from a short-term downtrend.

How are CFDs taxed?

No, CFDs are not taxed tools, and the only costs needed for them are spreads that you pay to a broker.

Is CFD trading safe?

CFD, like any other financial investment, involves risk, but it is not higher than other instruments. Both non-leveraged and leveraged CFD trading can bring potential risks, and everything depends on the direction of price movements and the correct forecast of it.

Leave a Reply

Your email address will not be published. Required fields are marked *