Contracts for difference (CFD) are a popular way of trading on the prices of stocks and indices, forex, commodities, and cryptos without owning the underlying assets.
A contract for difference is a popular kind of derivative in financing. Derivatives are time-limited contracts that primarily ‘derive’ their value from the market performance of an asset. What does CFD mean in trading? CFDs enable users to speculate on different financial markets. You do not buy the assets. Instead, you trade on the rise and fall in their price, normally over a short time.
A CFD is a contract between a broker and a trader who agree to exchange the difference in the value of underlying security between the start and the end of the contract, mostly less than one day. Thus, cryptocurrency day traders are mainly engaged in CFD trading.
A contract for difference (CFD) is:
- An agreement between the trader and the broker
- A derivative – you do not own the underlying asset
- Traded over a short time, mostly less than a day
- Based on the change in the price of the asset
CFDs Overview
A contract for difference (CFD) enables you to trade with only a fraction of the value of your trade, known as trading on margin, or leveraged trading. This enables traders to open bigger positions given their initial capital. Thus, CFD trading provides great exposure to the global financial markets.
One of the key advantages of CFD trading is that you can easily speculate on the asset’s price movements in either direction. You just sell or buy a contract subject to whether you think the asset’s price will go up or down. You open a long or a short trade accordingly.
Nonetheless, you need to always know that leverage trading can amplify your profits, but can also increase your losses.
How Does CFD Trading Work?
When you decide to open a contract for difference (CFD) position you choose the number of contracts (the trade size) you would like to sell or buy. Your profit rises in line with every point the market moves in your favor.
Buy
In case you are convinced that the price of an asset will rise, then you can open a long (Buy) position and profit when the asset price surges in line with your expectations.
Sell
If you believe the price of an asset will drop then you would open a short (sell) position and collect profits when the price falls in line with your predictions.
What Is A CFD Account?
A contract for difference (CFD) account enables you to trade on the price difference of different underlying assets using leverage. Leverage means that you put up just a fraction of the amount needed to trade. This is known as the deposit margin. You will also require to have enough amounts in your account to cover any possible losses in case the trades go against you. That is known as the maintenance margin.
The broker has to know a little about you before they can offer you any margin trading services. They ask you to set up a special account, proving your identity and ability to cover any losses that might come up. In most cases, you can practice trading in a demo account, but you will have to add funds to set up a CFD trading account before you can trade properly.
Some of the regulators need new clients to pass an ‘appropriateness’ test. This mostly means answering various questions to demonstrate that you understand the increased risks – and not just the possible rewards – of margin trading. It is highly advisable to thoroughly educate yourself on how leverage and margin work before trading.
Some of the experienced traders set up more than one CFD account with the same broker to trade various assets and follow alternative trading strategies.
What Is Leverage In CFD Trading?
Whenever you are trading contracts for difference (CFDs), you hold a leveraged position. It means that you just put down a part of the value of your trade and then borrow the remainder from your broker.
Leveraged trading is also known as trading on margin. A 10% margin means that you need to deposit 10% of the value of the trade that you want to open. The rest is covered by your CFD service provider.
For instance, in case you want to place an order for $1,500 worth of Brent crude oil and your broker needs 10% of the margin, you will need just $150 as the initial amount to open that trade.
Spread And Commission
With CFD trading, you are always offered two prices according to the value of the underlying instrument: the sell price (bid) and the buy price (offer).
The price to buy is always set higher than the current underlying value and the sell price will always be lower. The difference that exists between these prices is known as the CFD spread. Some brokers do not charge CFD commission on any trades made with them. Always do a background check before choosing a broker.
- The sell price (bid) is the price of the asset at which you open a short position
- You close your position whenever you buy
- The buy price (offer) is the price at which you start, or open, a long position
- You close that position when you sell
For instance, in case you expect the price of gold to surge you may want to open a position with a CFD on gold. Imagine the quoted price is $1,600/$1,605 (this is the bid/ask spread) and you purchase 100 CFDs on gold (taking a long position). The size of the position taken (the contract value) is provided by the broker.
In case the price of gold increases as expected, you will reap huge profits.
How Much Do You Need To Invest?
CFD trading democratizes the markets by offering a low entry level. Some brokers let traders open positions worth over $1,000,000 at a time but the minimum deposit that you can trade with is only $20 (€20, £20, 100PLN). For anyone using a wire transfer, the minimum deposit is €250.
You can open an account for free and practice in demo mode. Some platforms are flexible and scalable solutions for all traders, irrespective of their risk appetite, experience, or the amount of money they have to trade.
CFD trading is considered a cost-effective method of joining the financial markets. With some brokers, CFD costs include a commission for trading different financial assets. But, some brokers never take commissions for opening and closing trades, withdrawals, or deposits.
The main CFD cost is the spread – the difference between the sell and buy price at the time that you trade. There is an extra charge for an overnight fee, which is taken in case a trade is kept open overnight.
As contracts for difference are leveraged products, you can open a much larger position with a lower initial deposit than you need to acquire the traditional shares. For instance:
Buying Apple | CFD trade | Share trade |
---|---|---|
Sell / Buy Price | 135.05 / 135.10 | 135.05 / 135.10 |
Deal | Buy at 135.10 | Buy at 135.10 |
Deal size | 100 shares | 100 shares |
Funds required to open a trade | $ 2,702 = $135.10 Buy price x 100 shares x 20% margin (Margin required) | $13,510 (100 shares at 135.10) |
Close price | Sell at 150 | Sell at 150 |
Profit | $1,490 ((150 – 135.10) x 100 shares = $1,490) | $1,490 (15,000 – 13,510 = $1,490) |
What Assets Can You Trade With CFDs?
You can trade CFDs on indices, shares, currencies, commodities, and cryptocurrencies. Your broker offers access to thousands of different CFD assets across these classes. Hence, you are just a few clicks away from trading the world’s most popular markets in a single place.
The choice of available CFD options is continuously growing. In 2020, most of the brokers expanded their offerings and added new markets, which introduced many new attractive trading opportunities. Some of the new introductions include: futures (US crude oil, UK Brent oil), thematic indices (Corona anti-virus index, Crypto index), MOEX, cryptos, and SGX-traded stocks.
Example CFD Trades: Short, Long, And Margin Trading
Contracts for difference enable you to speculate on assets’ price movements in either direction. It means that you can profit when the markets go up (go long), and when they go down (short) in price.
- If you think that the market will surge, you ‘Buy’ or ‘go long’
- If you think the market will drop, you ‘Sell’ or ‘go short’.
Whenever you open a CFD position, you choose the number of contracts you would like to trade (buy or sell) and your profit will surge in line with every point the market moves in your favor.
An Example Of Going Long
If you think Tesla shares are going to appreciate and you want to open a long CFD position to profit from that opportunity. You buy 100 CFDs on Tesla shares at $190 per share, so the total value of the trade will be $19,000. In case Tesla appreciates to $200, you make $10 per share, which is $1,000 in profits.
The steps in the example below are:
- 195 You begin looking at the market
- 190 You see the price drop and decide to open your trade (Buy the CFDs).
- 200 You see the price of your CFD surge and close your trade (Sell the CFDs), which makes a profit of $10
An Example Of Going Short
For instance, you think that the Tesla price will drop, and you want to profit from the movement. Open a short CFD position (called short-selling) and profit from a dropping market.
This time, let us say to decide to sell 100 CFDs on Tesla at $200 per share, which then plunges to $190 per share. You will have made a profit of $1,000, or $10 per share.
The steps in the illustration below are:
- 195 You begin looking at the market
- 200 You see the price of your CFD surge and open your trade (Sell the CFDs), making a profit of $10
- 190 You see the price drop and decide to close your trade (Buy the CFDs).
Margin Trading Example
What is margin CFD trading? Leveraged trading is also known as margin trading. That is because the funds needed to open and maintain a position, known as the CFD margin, are just a part of the total trade size.
You need to know two kinds of margins when trading CFDs.
- Deposit margin – this is the amount needed to open a position
- Maintenance margin – that might be needed in case your trade begins making losses that are not covered by the deposit margin or extra funds that are held in your account.
The margin needed is subject to the deal provided by the broker and varies between the asset classes and within various regulated areas.
For instance, you purchase 100 CFDs on Tesla at $175.10. The initial outlay is $3,502 ($175.10 Buy price x 100 shares x 20% margin). The value of Tesla stock moves to 190 and then you decide to sell at the value – a $14.90 increase.
The profit made is $1,490, calculated by multiplying the increase with the number of contracts bought (14.9pt increase x 100 shares = $1,490).
CFD trade | Share trade | |
---|---|---|
Sell / Buy Price | 135.05 / 135.10 | 135.05 / 135.10 |
Deal | Buy at 135.10 | Buy at 135.10 |
Funds available (Balance) | $ 3,000 | $3,000 |
Leverage | 5:1 | 1:1 |
Deal size | 100 shares | 20 shares |
Funds required to open a trade | $ 2,702 = $135.10 Buy price x 100 shares x 20% margin | $ 2,702 = $135.10 Buy price x 20 shares |
Close price | Sell 100 shares at 150 | Sell 20 shares at 150 |
Profit | $1,490 (14.9pt increase x 100 shares = $1,490) | $298 (14.9pt increase x 20 shares = $298) |
Profit And Loss
After you spot a trading opportunity in the market and you are ready to trade, open a position depending on where you think the market will go. From that point, your CFD profits or losses will move in line with the underlying asset price in real-time.
You will be able to monitor all the positions that you have opened within the platform and close the positions when you want.
Loss and profit are easily calculated: you multiply the number of contracts you hold by the difference in price. Your profit-to-loss ratio, mostly abbreviated to P&L, can be defined using this formula:
P&L = number of CFDs x (closing price – opening price)
For instance, in case you were to buy 1,000 CFDs on Aviva at 400p per share and sell them at 450p per share your profit would be £500. This is illustrated below.
What Is The Contract Length Of CFDs?
A majority of the CFD trades do not have a fixed expiry date, which means that the CFD contract length is unlimited. A trade is closed just when placed in the opposite direction, which means that you can close a buy trade on 100 CFDs on silver just by selling these CFDs.
Nevertheless, in case you want to keep your daily CFD trade open after the cut-off time (normally 10 pm UK time, but can vary for the international markets), you get charged an overnight funding fee. Some of the best brokers just charge overnight fees on the leveraged portion of your trade and not on the total trade size.
Advanced Strategies For Risk Management Using CFDs
CFDs are described as complex instruments and trading them incorporates a high degree of risk. The value of trade can rise and fall. Hence, you might suffer losses when the market moves against your expectations. It means that CFD risk management is one of the critical points of consideration and implementation in your trading practice.
After setting up your account and devising a trading plan, it is crucial to determine how much you are willing to risk to formulate an appropriate CFD risk management strategy. In case you are risk-averse, then you will be looking for opportunities with lower risk-to-reward (R-R) ratios.
For example, in case you are looking for slow and steady growth, the asset classes with increased volatility should account for a small part of your portfolio. It is highly recommended to diversify across all asset classes to increase the likelihood of attractive trading opportunities and to mitigate risk.
Take-Profit And Stop-Loss
It is advisable to set up limit orders to automatically close out a position at a particular profit level so that you will not need to watch the market continuously. The take-profit orders minimize the likelihood of you holding on to a winning trade for too long and seeing the price drop again. Always trade with your head and not your heart.
Also, you can place stop-losses to minimize CFD risks and limit your possible losses. A stop-loss is a point at which a position is automatically closed out in case the price of the asset plunges below the amount you decide, in advance, that you are ready to lose.
Stops and limits are critical risk management tools and it is strongly advisable to use them.
Negative Balance Protection And Margin Closeout
In case you make a trade and it is not going how you had expected, some brokers protect you from losing more than you had invested. To keep the positions open, a trader has to meet the maintenance margin requirement; the minimum value of funds required to be kept in a margin account to cover any credit risks while trading.
The value maintained in a margin account works as collateral for credit. In the incidents where your exposure is about to surpass the maintenance margin requirement, the broker notifies you through a ‘margin call.’ That is where you either need to top up your balance or close some of the positions.
In case you do not act and the closeout level is reached, the positions are automatically closed.
With negative balance protection, you can be sure that your account balance will never drop below zero. In case a market moves against you abruptly, some brokers close the affected positions to protect you.
Experts advise that you should employ risk management strategies in all trades and be careful when trading CFDs on assets that are highly volatile like cryptos. Before investing, consider whether you understand how CFDs work and whether you are ready for the risks and losses that come with CFD trading.
Buy Crypto NowHedging
Hedging in trading is a critical risk management strategy used by experienced traders.
A hedge is a risk management technique used to reduce losses. You hedge to protect your profit, mostly in times of uncertainty. The idea is that in case one investment goes against you, your hedge position goes in your favor.
CFD hedging offers a chance to protect your active portfolio since you can sell short by speculating on a price downtrend.
For instance, you have an existing portfolio of blue-chip shares. You need to hold them for a long time, but you feel as if the market is about to witness a short dip, and you are worried about how this will impact the value of your whole portfolio.
With leveraged trading, you can short-sell the market to hedge against the downtrend possibility. Then, in case the market drops, whatever you lose on your portfolio can get offset by the gain from your short hedge using CFDs. In case of the market surges, you will lose on your hedge but eventually gain on your portfolio.