CFD stands for Contract for difference. It is a contract between a financial broker and a trader.
The trader trades financial derivative products that are obtained from computing the difference in the prices of two physical financial assets. This gives traders and investors the opportunity to make money from the prices changes without having to own the physical financial assets.
The trader exchanges the difference in the prices of the financial assets and in the process makes profits or losses depending on their speculations.
How does CFD trading work?
Let us look at an example.
An investor eyeing to buy more Great British pounds using the Dollar could opt to physically own USD dollars and wait for their value to rise so as to exchange them with Great British Pounds.
But a CFD trader does not have to physically own the US dollars. He/she just have to open an account with a CFD broker and set his or her base currency as Great British Pounds. Then, he would wait until he/she is able to speculate that the price difference between the two financial assets (USD and GBP, normally indicated as USD/GBP or GBP/USD) is going to rise. The price difference is commonly referred to as the exchange rate.
When the trader speculates a rise in the exchange rate, then he/she would enter into a contract with the broker to buy the difference in price at the current price and then close the contract once the price hits a certain level thus making a profit from the rice in the exchange rate. If the difference in price drops instead of rising as anticipated, then the trader ends up making a loss instead of a profit.
Common Terms in CFD trading
It is important to understand some of the common terms that you will encounter in CFD trading.
Below is a summary of the most commonly used terms/phrases:
CFD broker: this refers to an institution which provides the services of CFD trading. It gives the trader the platform to trade.
Deposit: the amount of funds you deposit with your CFD broker. This is the money that is used to buy and sell in the CFD contracts.
Position: this refers to a sell or a buy contract entered into between the trader and the broker.
Leverage: this is an amount of funds borrowed by the trader from the broker so that the broker can allow the trader to open a larger position than what his/her deposited funds can allow.
Leverage ratio: this is the amount of leverage that a broker gives. An example could be 50:1, 200:1, etc.
Margin: this is the minimum amount of deposited funds required to maintain a contract/position.
Initial margin: also referred to as the initial deposit. It is the minimum amount required to open a position. If your broker allows leveraged trading the margin required to pen positions is lower.
For example, if you wished to open a position of $5,000 and you choose to use the leverage of 50:1, you will only require a margin of $100.
Used margin: this refers to the amount of funds which are already used in opening a position/contract.
Balance: this is the total amount of funds remaining in your CFD account.
Equity: this is the overall value of a traders account. It is calculated as balance plus any loss/profit.
Available equity: It is also referred to as the free margin. It is the equity that can be used to open positions. The available equity reduces with the opened positions.
Lot: this is used to describe the size of your position. The value point of a lot size varies depending on the CFD market being traded.
For example, 1 lot of 100 GBP is 10 GBP, while 1 lot of gold is 100 ounces.
Buy position: it is also referred to as going long. It is a contract entered into by a trader and a broker when the trader anticipates that there will be a rise in the price difference (exchange rate). If the exchange rate rises, then the trader exits the contract/position having made some profits.
Sell position: it is also referred to as going short. It is a contract entered into by a trader and a broker when the trader anticipates that there will be a drop in the price difference (exchange rate). If the exchange rate drops, then the trader exits the contract/position having made some profits.
Profit: This is the amount of funds a trader makes if a contract/position goes in his/her favor.
Loss: this is the amount of funds a trader losses if a contract/position goes against his/her speculation.
Stop loss order: this is a way of managing the risk involved in CFD trading. The trader specifies a certain price level that a position will close in case the price goes against his/her speculation. It reduces the amount of loss a trader makes.
Take profit order: this is also a way of managing the risk involved in CFD trading. The trader specifies a certain price level that a position will close when the price goes according to his/her speculation. It ensures that the trader makes profits before the market prices decide to change and start dropping.
Call margin: this is also called close out. This is when all the open positions are closed because they have registered a loss equal to or greater than the available equity. When the positions are closed, the account balance is either left as a negative or at zero (this is if the broker has a measure to prevent negative account balance).
Overnight charges: these are sometimes referred to as swaps. They are charges by a broker when a trader holds a position overnight.
Assets Traded with CFD
Different financial assets can be traded as CFDs. The following assets can be traded as CFDs:
- Currency pairs: When traded as CFDs, it is referred to as Forex CFD trading.
- Indices: when traded as CFDs, it is referred to as Indices CFD trading.
- Commodities: when traded as CFDs, it is referred to as commodity CFD trading.
- Cryptocurrencies: when traded as CFDs, it is referred to as cryptocurrency CFD trading.
CFD Trading advantage
- Traders get a chance of trading with leveraged products.
- There is no limit of time to trade. Most CFD brokers allow trading 24 hours for the 5 business days.
- A trader is able to access a wide range of financial assets to trade on one trading platform. You could access Forex, commodities, Indices and cryptocurrency derived assets through one broker without having to create different accounts to trade different assets.
CFD Trading Disadvantages
- There is a week regulation of the industry and it is easy to get into a scam.
- Traders service the spread.