CFD (contract for difference) is a financial-derived trading arrangement. In CFD, differences between closing and open trade prices get cash-settled. It is also an advanced strategy of trading commonly used by experienced traders. It is, however, prohibited in the U.S.A.
When trading CFD, it means you have agreed to exchange an asset’s price difference from the moment the contract is opened to when it closes. A vital benefit of this kind of trading is that you’ll be able to speculate the movement of prices in all directions. As such, the loss or profit you will make will depend on whether your forecast was wrong or right.
Uses and features of CFD
1. Long and short trading
CFD enables you to simulate outmoded trades which profit with the rise of market prices. This also enables you to open CFD positions that still profit with the decrease of market prices. This is known as ‘going short’ or selling instead of ‘going long’ or buying.
For example, if you believe that a company’s share prices will fall, you have the option of selling shares CFD on that company. You will still be able to exchange the price difference between when your position is opened and closed. However, you will earn a loss if prices increase and profit when they drop.
Both short and long trades, losses, and profits are realized the moment the position closes.
Leveraging means you could have access to a more prominent position without pledging total costs at the start. Say you’d like to open positions equivalent to 500 shares of a company. Using standard trade, you’d have to pay the share’s total cost upfront. When using CFD, you might have to only part with as little as 5% of the set cost.
Leverage makes it easy for you to spread capital. Even so, it is worth noting that your loss or profit will still be calculated on your position’s full size. In the example above, that will be the price difference of the 500 company shares from when you opened to closed the trade. This means that losses and profits can be massively overstated compared to your outlay. It also means that losses can surpass deposits. As such, trade within your means and keep an eye on leverage ratios.
Leveraged trading can also be called ‘trading on margin.’ This is because funds that are needed to open and retain positions (‘margin’) represent a fraction of the total size.
CFD trading has two margin types, i.e., deposit and maintenance margins. Deposit margins are necessary for opening positions. Maintenance margins come in handy when the deposit margin trades are almost incurring losses – and the additional funds your account has won’t cover. When this happens, providers make margin calls requesting that you top-up funds in the account.
So, what happens when you do not add funds? The position could be closed, and this means you will realize all losses incurred.
You can use CFD to evade (hedge) against a standing portfolio’s losses. For example, in a situation where you think a company’s shares in your selection might suffer short-term value dips. Such dips may have resulted from a below-average earnings report. You have the option of offsetting some potential losses by using CFD trade to go short on the trade market.
Hedging risks in such a manner means that a short CFD-trade gain will equalize any decline in the company shares in your selection.
How CFD’s work
The following are some ideas behind CFD trading:
- Spreads: Are quoted in sell and buy prices. Sell prices, also called bid prices, are what you use to open short CFD. Buy prices, also called offer prices, are what you use to open long CFD.
- Deal size: Lots/standardized contracts are what’s used for trading CFDs. Contracts size varies depending on the asset on trade. They often imitate the way that asset gets traded in the market.
- Durations: There are cut-off times set, and if you keep a CFD position open past the set time, you will have to pay an overnight funding charge. This will reflect on your provider’s capital, i.e., the one lent to you to open that leverage trade.
- Loss/profit: Here is how you calculate profit or loss you’ve earned: profit/loss = (number of contracts x each contract’s value) x (closing price – opening price). To get the entire calculation, subtract any fees or charges you’d paid.
You can use CFD to trade several securities and assets. CFDs enable traders to trade assets’ price movement, including commodity features, stock indices, and ETFs.