When it comes to financial markets, there are numerous ways in which a trader can profit (or suffer a loss) from the movement of various assets. CFDs are one of them, but what is CFD trading and how do CFDs work?
CFD stands for contracts for difference. It’s a method of trading that allows traders and investors to profit from the movement of prices in a particular financial market without actually having to own the underlying financial asset. Because there is no actual ownership taking place, the actual asset is neither bought nor sold by the trader.
So, when someone talks about CFD trading, they’re talking about the buying of a CFD and the selling of a CFD i.e. the derivative product, and not the buying and sharing of the actual asset.
CFD trading allows traders to speculate across a range of markets including: the forex market, stock market, commodity market and indices.
The contract of difference outlines your agreement to the exchanging of the difference in the price of the financial asset in question, as calculated from the moment when the contract is first opened to when it is finally closed. Your profit and loss is thus determined by how correct your prediction of the price movement turned out to be.
If you take a short position in your CFD trading, that means that you’re expecting the price to decrease in the future (or more specifically prior to the contract being closed). This is called going short, or selling.
If you take a short position and the price has decreased when the CFD closes, you’ll have made money. If the price moves upwards, you’ll incur a loss.
Going long is the opposite: it’s the CFD position that indicates your forecasts of a price increasing and therefore, if it does, you profit from that difference when your position is subsequently closed.
An important point to note is that much like the cliche phrase that it’s not over until the fat lady sings, you’ve only profited or lost once the position is closed depending on where the price of the asset is. (Unless you cannot top up a required maintenance margin. See below for more on that.)
Movement or fluctuation up or down during that period prior to it being closed does not matter at the end of the day.
To understand CFD trading there are a couple of important elements to explain.
The price of a CFD represents both a buy/offer price and a sell/bid price. The offer price is the price level at which you can go long in your CFD, while the bid price is the level at which you can go short. Like all trading, the buy price will be pushed by the sellers to be higher and the sell price will be pushed by the buyers to be lower. A spread is the difference between these two price points.
A ‘lot’ is the industry term for the standard contract in a CFD. The size of the lots will be reflective of the market being traded in. CFDs in a share market will reflect individual shares per CFD, while in commodities it will reflect the going volume of that particular commodity bought and sold on a regular basis.
Once your position is closed you’ll realise the profit (hopefully) or loss (hopefully not). That profit is determined by the amount of contracts multiplied by the value of each of those contracts. That sum is then multiplied by the difference in price up or down from when the contract was opened to when it is closed.
Of course, this does not take into account any fees or overnight charges if you don’t close your position by the end of the trading day (futures contracts excepted). Having said that, the CFD trade closes only when the position is sold, and not at a predetermined fixed point in time.
When you purchase commodities, shares, or a foreign currency, you need to pay the full amount of the asset to acquire ownership of it. With CFDs, you’re not actually buying the asset so you don’t need the full amount of its cost. Rather your upfront cost is only a small percent of the value of the asset. This is called leverage. It means you can open a big position without having to pay big upfront. (Of course, that doesn’t mean you can’t lose or win big depending on the success of your forecasting.)
The deposit margin is the amount of money you need in cash for the trade to open. This in turn determines the leverage ratio: the deposit required as a fraction of the position’s size.
If your trade begins to incur losses, you may need to add more cash into the account if it gets close to exceeding your deposit margin. An inability to do this will result in your position being closed and you subsequently losing the money prematurely.
CFD trading is used by some investors as a way to hedge their risk and mitigate losses they may be incurring in another portfolio. A trader who owns a specific commodity which is dropping in price can hedge the loss by opening a CFD position and going short. Thus, they will make money with their CFD even as they lose money through their commodity holdings.
CFD trading offers certain advantages:
There are however disadvantages too that ought to be noted.
This last point is part of why CFDs are not offered in America nor encouraged by US regulators for engagement via foreign markets. In a country like Australia, where CFD trading is legal, it is heavily regulated by the Australian Securities and Investment Commission (ASIC).
We’ve just scratched the surface on what CFD trading is. If you’d like to know more about how it works, the risks involved or even what the best CFD trading platform is, our team of financial and trading experts are always ready to have a chat. Contact us today!