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Trading CFDs is becoming increasing popular among traders, and is a widely offered type of trading among all of the top online brokers. So, what exactly is CFD trading?
What is a CFD?
CFD stands for Contract for Difference. This is a particular type of derivative offered by brokers whereby you are trading on the difference in price of an asset between when you open the trade, and when you close the trade, though you are not actually purchasing the underlying asset.
One of the big attractions of this type in investing is the flexibility it allows for. With traditional trading, you are tied to buying the asset basically for it to move in one direction, up. With CFD trading though, you choices are much more open. You can speculate on movements up or down when you buy in to the contract. Here we will take a more in-depth look at how CFD trading works, and the tools you have at your disposal when trading.
Going Long or Short in CFDs Trading
This ability to go long or short is a key benefit which CFDs trading has available that is not available in a more traditional sense of trading without the use of options, or possibly investing in a complex ETF or other type of fund.
Going long on a CFD means that you believe the asset you are investing in will go up in price. Therefore you would place a “buy” order for that asset.
On the other hand, going short on a CFD means that you believe the asset you are investing in will go down in price. In this case you would place a “sell” order for that asset.
In both cases, you profits from trading CFDs will be calculated only when you close the position. At that point of closing, you will make a profit or loss for the difference in price.
You see Tesla is currently priced at $440 per share, and you believe the value will increase. In this case to make a profit you would “buy” Tesla. If the price at closing has gone up, then you will profit. If it has gone down, you make a loss.
Similarly, if you see the Euro currently valued at $1.17 against the USD, and you think this will go down, then you open a “sell” position with your CFD. If the price Euro does then decline below $1.17 then you will make a profit. If the price goes up though, you will make a loss.
As you can see, going long is effectively betting that the price of the asset you choose will go up, whilst going short is forecasting the price of the asset will go down. You can also see from this example that there are usually a host of assets available from the top CFDs brokers that you can trade. These usually include many forex pairs, stocks, commodities, bonds, and even cryptocurrencies.
Using Leverage in CFDs Trading
As well as the flexibility you can enjoy with CFD trading, you can also benefit from trading on leverage. All CFD trading is done on leverage. This means that you only have to pay a small amount of the contract cost up front.
Leverage increases your trading power, in that you can open large positions with a smaller amount of capital. For example, if your broker allows a leverage of 30:1 (the maximum amount allowed under CySEC regulations in Europe, then you could open a $30,000 trade with a cash balance of $1,000.
Leveraged trading can be great for giving you essentially more buying power as a CFDs trader, but you should also remain mindful that, while the potential rewards are magnified, so too are the risks. Losses can mount quicker the higher leverage you use, so you should always ensure that you have sufficient funds and employ a solid risk management strategy.
What is the Margin and Hedging?
Leveraged trading of CFDs can also be referred to as margin trading. The margin comes in two different forms. Firstly, this is the amount of money you must deposit initially in order to open a leveraged trade. This could be between 2% to 50% of the trade size depending on the leverage ratio. Then, you may have to deposit a further margin if a trade is going against you. In this case, you may receive a margin call from the broker. This is asking you to deposit more funds if you wish to keep the position open.
CFD trading can also be a great way to hedge against any other holdings you have in your portfolio. Traders will often use CFDs in this way since it is quick and easy to go short on particular assets. For example, if you have a holding of Apple shares in your stock portfolio but fear they may start losing money, you could offset this by opening a CFD which shorts Apple.
The Process of Trading CFDs
With a clear understanding of the background, you will be ready to trade CFDs. Here there are a few points to consider, and steps in the process to complete when making your trade.
One of the first things you will commonly notice is that there is often a buy, and a sell price. The sell price will always be slightly lower than the current market price, and the buy price slightly higher. This price difference is the broker spread, a small profit which they make on your trades that is typically kept as competitive as possible.
Another point to note is that CFDs trading is done in lots. You will need to be aware of the lot size on an asset before opening your position. These can vary depending on the asset, though shares CFD trading is usually 1 share per lot.
When it comes to how long you need to keep a trade open for, this is also completely up to you when trading CFDs, though you should double check with your broker for any overnight fees which are charged if you keep a position open overnight.
Where to Trade CFDs
There are many places to trade CFDs online. We currently recommend the following:
Warning: Please be aware that all trading involves risk. 67% of retail investor accounts lose money when trading CFDs with this provider. You should consider whether you can afford to take the high risk of losing your money. This content is for educational purposes only and is not investment advice.