CFDs, or Contracts for Difference, are a financial product that enables traders to speculate on the price movement of an asset without owning the underlying asset.
CFDs allow traders to take larger position sizes when trading, by using leverage.
They also allow traders to trade either long or short, which means they can take advantage of either rising or falling prices.
What is a CFD?
CFD stands for Contract for Difference. They are a financial product or ‘instrument’ offered by many brokers around the world.
They are a derivative product, which means they allow traders to speculate on the price movement of an asset without actually owning the underlying asset.
With this form of trading, you don’t own the asset, you just get exposure to its price movement.
In essence, they are a contract between the trader and a broker, settling the difference in the asset’s value between the entry and exit points of the trade.Hence the term ‘contract for difference’.
Markets available to trade
CFDs are available for a wide range of financial markets:
- Forex
- Indices
- Gold and other metals
- Cryptocurrency
- Stocks
- ETFs
There are several aspects to understand when trading CFDs.
The first of these is leverage.
Leverage
CFDs allow you to trade using leverage, which means you don’t have to have the full value of the trade in your trading account.
Effectively, the broker ‘loans’ you a percentage of the cost of your trade.
This percentage is known as the ‘margin’ on offer, and can range from 2% right up to 80% or more.
The higher the margin figure, the higher the percentage of the trade value you have to physically have in your trading account.
For example, if you were trading on 2% margin, and your trade was worth $100, then you would only have to have $2 in your trading account to cover the cost of that $100 trade.
If you were on 80% margin, you’d have to have $80 out of the $100 value of the trade.
Controlling your leverage
Leverage magnifies your trading power, potentially allowing you to make a larger profit. However, it amplifies the potential for losses too.
This makes learning risk management skills important to every CFD trader.
It’s also important to understand that your trading profits or losses are based on the full value of your trade, so you can potentially lose more than the value of the trade you place.
Because of this, it’s critical to note that you do not need to max out your leverage.
You can take small trades that only take up a portion of your available margin.
Overnight financing
When you trade CFD’s your position will be subject to overnight financing costs.
These costs will reflect the underlying interest rate of the marketyou are trading.
For example, if you are trading UK stocks the interest rate will be based on the interest rate in the UK.
Interest rates are subject to a markup by the broker who is providing the CFD.
For example, a broker may mark up the interest rate by 1%.
While you may normally be paying interest, there are times when you will receive interest.
If you are ‘short’ a stock you could receive interest, although you would pay any dividends due on a stock CFD.
If you buy a high interest rate currency against a low interest rate currency, such as AUD/JPY, you can earn interest. This is called a ‘carry trade’.
Any fees and charges should be clearly displayed either on the brokers’ website, or on the trading platform.
Ability to go long and short
CFDs allow you to trade in both directions, both up and down, or long and short.
Short trading means that you place a trade hoping for a price reduction in the asset you are trading.
You want prices to go down, not to go up.
It is the exact reverse of a long trade, where you’re hoping that prices will increase.
The profit you make from a short trade is the difference between your trade entry point, and your exit point.
The difference is that to open a short trade, you first have to sell the CFD asset. This selling action opens up the trade.
Next, you hope the prices falls, so you can close the trade at a lower price.
This buying action ends the trade, so you no longer have an open position.
Your profit is the difference between your sell price and your buy price.
In reality, short trading using CFDs is very simple.
All you have to remember is that when trading short CFDs, you SELL the asset to open your trade, and BUY the asset to close the trade.
It’s the exact opposite to trading a long position.
What happens if you short a trade and the price goes up?
If you decide to take a short position, and the price of the asset rises, you’ll make a loss.
Remember the loss will be based on your total position size, not just the portion you fund from your account.
Trading on margin using leverage is a popular trading strategy which can assist you to make larger profits than you would be able to if there was no leverage involved.
However, you should be aware of the increased risk, because not only are your profits magnified, but your losses can be magnified too.
Is trading with CFDs suitable for beginner traders?
Trading using CFDs is suitable for you if you are a beginner. This is because you can access a wide range of markets, use leverage, and easily go long and short all in one account.
A top tip for beginners is to understand the implications of using leverage before you start to trade.
It can be a good idea to place some trades in a practise account so you can understand how leverage works in a practical way.
Next, as a beginner trader you will want to learn how to trade in a safe way using risk management.
