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A contract for difference (CFD) is a contract that allows traders to trade on the price movement of securities and underlying assets. A CFD is a contract enabling parties to trade the difference between the entry and closing prices of a security or asset.
How Does CFD Trading Work?
With CFD trading, you do not need to buy or sell physical assets like stocks, bonds or shares. Instead, you purchase or sell a range of units for a particular financial instrument, called CFD units, based on your belief that prices will go up or down.
For every point the price moves in your favor, you gain multiples of the number of CFD units you have bought or sold. For every point the price moves against you, you will get a loss.
Benefits of CFD Contracts
- Wide range of assets and flexibility
A CFD offers the opportunity to trade a wide range of assets. You can get access to trade contract of differences in over 17,000 markets, including global indices, currencies, stocks, forex, cryptocurrencies and more.
There is also the advantage of trading some markets after trading hours, although after-hour prices might differ from the market opening price.
- The opportunity to leverage
The opportunity to leverage is perhaps one of the most important advantages of CFD contracts. With CFDs you do not need to pay for the entire value of your position; you only need to pay a small amount known as the margin.
The small amount you deposit is the “margin” and it is only a fraction of the asset price. You can pay as little as 0.20% margin investment with some brokers. How much you’ll need to deposit largely depends on your position’s size and the margin factor for your chosen market. However, it’s important to remember that your total profit or loss is based on your position’s full size, not your deposit.
- Benefit from both positions
With CFDs, you can benefit from going long or going short. When you buy to profit from rising prices, it is called “going long” while buying so that you can profit on falling prices is called “going short” or short selling.
- Hedging your portfolio
Hedging with CFDs allows you to hedge or protect your portfolio from sudden, unexpected losses. With CFDs, traders can protect the total value of open positions while only having to pay a margin or small percentage of the price upfront.
Risks of CFD Contracts
CFD contract trading no doubt comes with excellent benefits. However, there are some risks to note before and during trades.
- Risk of huge market losses
Because of the leveraging effects of CFD contracts, traders can lose more than their margin deposit if the market moves against them. This is because marginal rates are usually small and, therefore, small amounts of money can be used to hold large positions resulting in huge losses should the market close in an unfavorable position.
- Risk of liquidation
There is the inherent risk of loss due to short notice in a fast-moving market. This happens when the price moves against an open CFD position and the seller is unable to provide additional deposits (variation margin) needed to maintain or balance out that position due to short notices. When this happens the position is closed, leaving you to bear the loss.
- Counterparty risk
CFD traders could potentially incur severe losses, even if the underlying asset moves in the desired direction if the broker goes insolvent and is unable to carry out their financial responsibilities.
Contract for Differences Terminology
Some commonly used terminologies in trading contract for differences are these:
- Going short and going long
Going short or shorting is hoping to benefit from the decline or fall of asset prices.
Going long happens when traders open a contract for different positions anticipating an increase in the underlying asset price.
A lot is defined as the size of your CFD trade. In trading CFDs, lots vary between each market.
- Initial margin
The initial margin is the amount that is required to open the position. It is often referred to as an “initial deposit.”
Considerations for CFDs
If you are thinking of trading CFDs, here are some features to consider before you trade CFD contracts.
The spread is the difference in price between the bid price and the ask price of an asset or security. The trader usually pays a slightly higher ask when buying and accepts a slightly lower bid price when selling. The spread, therefore, is the transaction cost to the trader.
Most CFD trades have no expiration dates — compared to other options and trades. Instead, a position is closed while a trade is in progress by placing a different trade in the opposite direction to the first or initial one that was opened.
- Deal size
The size of individual CFD contracts varies depending on the underlying asset being traded on the market. CFD contracts are made to mimic how that asset is sold on the market.
- Profit and loss
In calculating the profit or loss earned from a CFD trade, you multiply the total number of contracts by each contract’s value. The result obtained is multiplied by the difference in points between the price when the trade position was opened and when it was closed.
Contract for differences can be used to trade many assets and securities, such as exchange-traded funds (ETFs). Traders use CFD contracts to speculate on the price movement of assets without physically owning the assets. CFDs aren’t traded on major markets like the New York Stock Exchange (NYSE) but you can trade over-the-counter (OTC) via a network of brokers that coordinate the market demand as well as supply for CFDs and fix prices accordingly.
Costs of CFD Trading
- Overnight fees
Overnight fees are charged for shared CFDs. It is a commission you pay or receive to keep a buying and selling position overnight on CFD trades with no established expiry date. It’s an additional cost paid to cover the overnight cost of the leverage.
- Holding costs
Traders are charged over open positions at the end of the trading day. These charges are referred to as the holding cost and they can be positive or negative, depending on the difference between the bid price and the ask price.
- Commission charges
Commission charges only apply to shares. Commission charges are the charges CFD brokers charge for trading transactions.
- Market data fees
Market data fees are fees that trading platforms charge to trade or view price data for certain assets.
Example of CFD Trades
Example 1: Going long
Say Disney is trading at $98 /$100 (where $98 is the sell price and $100 is the buy price). The spread in this case is $2.
If you speculate that the company’s price will go up, you can decide to open a long position by buying 10,000 CFDs at $100. Assuming Disney price appreciates to $115, you will make a profit given by (close price – open price) x share, or
$15 per share = ($15 x 10,000) = $150,000
Example 2: Going short
Say a stock has a share price of $25 and a trader speculating a fall in price decides to sell 100 shares. Assuming the price depreciates to $20, you will make a profit given by ($25 – $20) x 100 = $500.
Tip: This calculation, among other things, didn’t factor in the commission the trader paid in going long overnight, which is important in calculating the net profit.
Best CFD Trading Platforms
In choosing the right CFD broker, it’s essential to consider several important factors, including costs, regulations and the number of tradable assets available.
CFD trading has the potential for worldwide growth and offers immense benefits to traders. However, this is not financial advice and it is important to carry out due diligence before trading.
Frequently Asked Questions
What happens when you buy shares of CFDs?
When you buy shares of CFDs, you do not physically own the asset and you only need to pay a small percentage of the total worth of the trade to open a position.
Why are CFDs banned in the United States?
CFDs are banned in the U.S. by the Securities and Exchange Commission (SEC) because they are not regulated and majorly traded OTC.
How long can you hold CFDs?
Traders can hold long-term and short-term positions for as long as they can afford to fund the position because CFDs do not expire.
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