How Does CFD Trading Work?

CFD stands for ‘Contracts for Differences’ and before we tackle the topic of how to trade them it’s important to understand what do traders talk about when referring to CFDs.

In this article we will explain how CFD trading works and cover the following topics:

Define CFDs

Contracts for Differences (CFDs) is one of the most innovative trading tools and its popularity in Australia grows by the year. CFDs allow you to bet on increasing or decreasing prices on any financial market: currencies (e.x. Forex), stocks (Apple, Tesla, Google, etc.), commodities (oil, gold, corn, etc.) or indices (stock market indexes e.x. S&P 500 Index). When trading CFDs you make a contract with a CFD broker and you can make money (or lose them) without owning the underlying asset.

How Does It Work? – The Trading Process

So this is how to trade CFDs:

If you think that the price of an asset, let say “Apples and Oranges Inc.” stock shares, is going to increase you can buy a CFD and benefit on that rise. This is also referred to “going long” or “opening a long position”.

  • Buying = Expecting to make profit on rising prices = Opening a long position

However, when trading CFDs you can also benefit on falling prices if you sell CFDs or in other words if you “go short”.

  • Selling = Expecting to make profit on falling prices = Opening a short position

The profit or loss of a single CFD trade in both cases, i.e. “going long” and “going short”, is equal to the delta (or the change) in the price of an asset times the leverage. We will explain the leverage effect later in the review.

Let’s say the current price of a “Apples and Oranges Inc.” share is $587. The stock market can go two ways: the price for a share might go up or down. Let’s see how you can make profit trading CFDs with both rising and falling asset prices:
1.      You have bought 10 CFD for $587 with a leverage of 1:100 and closed it when the price was $595. Then your profit is equal to the number of CFDs x the change in share price x the leverage.
10 x $8 x 100 = $8 000.
2.      You have sold 1000 CFD for $587 with a leverage of 1:100 and closed it when the price was $583. Similarly, your profit is equal to the number of CFDs x the change in share price x the leverage.
10 x $4 x 100 = $4 000.
 
In both of these scenarios you have entered a market when the price of an asset was $587. If you bet correctly on how the price is going to change you can make profit by both buying or selling CFDs.
 
When we calculated profits above you might have noticed that we had to account for the leverage. Leverage is something you can benefit from when trading CFDs. We will cover the leverage effect concept further down, so keep on reading!

Variety Of CFDs

There are many varieties of CFDs that depend on what kind of price difference a client would like to speculate. Let’s have a look at some examples:

  • Share CFDs – the type of contract that resembles stocks trading making it more attractive to experienced stock trading experts. It is the most popular one in the marketplace. The price of a CFD derives from the underlying share.
  • Index CFDs – one of the most liked CFDs because of the advantages it offers: high volatility and leverage, low margin, and trading price. The popular indexes for index CFDs traders are London Stock Exchanges, the Australian Stock Exchange, Dow Jones, Nikkei, and others.
  • Commodity CFDs – contracts that are based on the differences in prices of two types of commodities: hard (the ones that are mined) and soft (the ones that are grown).
  • Sector CFDs – allows investors to speculate on the growth or stagnation of different economies. For instance, if you choose a healthcare sector, you will need to take into account an overall state of things in the economy sector rather than in individual companies.

If you are a beginner broker, it is always better to stick to the smaller number of markets that you are familiar with. For example, start with one variety of CFD like hard commodity CFD and investigate this in detail to make better predictions.

How CFD Brokers Operate

So let us sum it up for you how you can trade CFDs through brokers. Contract for Difference is a trading tool that enables investors to enter the financial market without having to buy or sell an underlying asset. Losses and profits are calculated and granted after the contract is exited. The calculation is based on the difference between the ask and bid prices. If you benefited, the broker with whom you entered the CFD will pay you the difference. If it is a loss, then it is up to you to compensate the difference in prices to your broker.

The main benefit (see all the benefits of CFD trading) of CFDs is that available leverage is higher with this type of contract in comparison to traditional trading, like trading shares. Thus, traders invest only a small part of their own funds relying on their brokers to provide the rest. Reliable brokers offer smaller margins to lower the risks for traders.

What is Leverage in CFD trading?

When buying CFDs you don’t have to pay the full price of your position, but only a fraction of it. This practice is called “trading with a leverage” or “trading on margin”. This allows traders to open more positions than they initially could with their budgets.

Here is how leverage effect works on our previous example: let’s say the current “Apples and Oranges Inc.” share price is $587 and you expect it to rise in the near future. So, you buy 10 CFD and your broker provides a margin rate (or a leverage) of 1 to 100, or 1%. 1% margin rate means that you only need to pay 1% of the whole price to open a long position, or similarly you only have to sell 1% of the total portfolio value to open a short position.

  • 10 CFDs = 10 x $587 = a total of $5 870 of traded position
  • With a leverage of 1% you only have to pay 1% of $5 870 = $58.7

In a situation when you have bet correctly and bought 10 CFDs and then the price of an asset rises as you have planned you make a profit which is equal to:

the number of CFDs x the change in asset price x the leverage.

With a $8 price increase your profit is 10 x $8 x 100 = $8 000.

In a situation when you have bet correctly and sold 10 CFDs and then the price of an asset falls down as you have planned you, again, make a profit which is equal to

the number of CFDs x the change in asset price x the leverage. With a $4 price decrease your profit is 10 x $4 x 100 = $4 000.

There is, of course, a downside to the leverage effect because you are just as likely to lose as to expect to have a higher return on your investment. There is a substantial risk involved when trading CFDs with leverage. When the position moves against you the opposite side of the leverage effect impacts your losses. You can expect to have high percentage losses when trading CFDs if the price of the underlying asset goes another way.

Advantages Of CFD Trading

Deciding to focus on CFD trading is a wise choice because this type of trading brings a lot of advantages. To sum up, let’s list some of them:

  1. One of the best features of CFDs is that you do not own any underlying assets
  2. With CFDs, you will be able to trade an unlimited variety of financial assets. Here are some examples: shares, indices, cryptocurrencies, metals, oil and other hard and soft commodities, etc.
  3. Plenty of various trading tools (like charts, news feeds, etc.)
  4. Trading with significant leverage
  5. Reliable risk management instruments
  6. A lot of brokers offer a great choice of up-to-date educational materials on CFD trading

Conclusion

CFD trading is a marvelous opportunity to earn a profit on the difference between buying and selling asset prices. Use all the benefits of this type of trading with the best CFD broker. Choose such a broker from the ones presented our reviews and nothing will stop you from gaining your profit!

  1. How to choose the best CFD broker?
  2. CFD Trading Vs Shares Trading
  3. CFD Trading Vs Options Trading
  4. CFD Trading Vs Futures Trading

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