A CFD, or Contract for Difference, is a type of derivative that allows you to trade an asset on the global market without owning it. Some other popular types of products are Options, Futures, and Swaps.
When trading CFDs, you do not own the actual assets. You will calculate your profit based on the change in the underlying asset price between the start and end of the contract. The main difference between CFDs and other derivatives is that the contract end (expiration) date is not fixed, which means you can keep your contract for as long as you like.
One of the prominent benefits of trading CFDs is that you can speculate on assets and profit both in bullish and bearish directions. Your ability to estimate the market will determine the amount of profit/risk you make. With the CFD engine, you can access and trade various underlying assets, such as currency pairs, stocks, stock indices, cryptocurrencies (including Bitcoin), and commodities.
However, you need to understand how CFDs work before entering a trade.
Video: Explanation of CFD
How does CFD trading work?
To understand this whole process, you first need to understand the concept of “Margin Trading.” CFDs are leveraged, which means you only have to deposit a portion of the money instead of the entire contract value when making a trade. To be more precise, leverage allows you to enter the market with much more purchasing power than the capital in your trading account.
CFD Trading: What is a CFD Margin?
To start trading CFDs, you need to open a “margin account” with a licensed and regulated broker. This broker will help you increase your purchasing power by providing leverage, and you will have the opportunity to make more profit with only small capital. However, keep in mind that leverage can also increase losses, so choosing a reasonable level of leverage is very important.
To maintain your margin account and trades, you will need to “deposit” a certain amount; This amount is like insurance if your trades fail. It is also known as the “initial margin” or “margin deposit” amount so that you can borrow from the broker (via leverage) and execute your trade.
If a loss occurs and your account capital drops to a certain level, the broker will make a “margin call.” You will be required to deposit a certain amount of money into your account to maintain your trades (also known as the “maintenance margin”).
Assume shares of Company XYZ are trading at $130 per share. You decide to buy 1,000 units of a contract at this price. At this point, if you want to pay the full value of this contract, you will have to pay:
$130 x 10,000 = $130,000.
By using leverage, you can access the same number of shares but with a lower investment. If the margin required is 5% of the total trade value, you will only be required to pay 6.50 USD per unit of CFD in your trading account as margin.
So your total margin requirement will be
(0.05 x 130,000) = $6,500.
This is a lot less than the $130,000 figure, but you have the same access as if you had bought the stock directly. In addition, you are entitled to 100% of the profits. On the other hand, you will also bear 100% of all losses.
The margin percentage will depend on the country where you trade. Each regulator will set different limits on leverage; These limits are intended to protect traders against significant losses during periods of high market volatility.
Buy (long) or Sell (short) in CFD trading.
When trading CFDs, you can speculate on both the rising and falling directions of the market. If you believe the price will go up in the future, you will buy into the underlying asset (go long). Conversely, if you think the price will fall, you will sell the asset (go short). Your profit will be calculated based on the price change between opening and closing the order, and the exciting thing is that you can still profit when the price drops.
Leveraged CFD trading example
Let’s say you want to trade CFDs on the US30 index (also known as the Dow Jones Industrial Average), and the index is at:
The difference between the Bid and Ask prices (Bid/Ask Spread)
At this point, “Bid” will be the selling price – the price at which you sell the asset. The higher level is the “Ask” price, also known as the buy price – the price you buy the asset. The difference between these two prices is called the “spread,” which is the transaction fee. Spread can increase or decrease depending on the liquidity of the asset and the broker you choose to trade with. If trading at one broker, spreads can be very low as these brokers often get quotes from various liquidity providers and quote you the best price.