CFD trading: Invest in price movements in both directions
CFD trading is defined as "the buying and selling of CFDs". CFDs are a derivative product because they allow you to invest in markets such as stocks, currencies, indices, and commodities without having to purchase the underlying assets.
Instead, when you trade a CFD, you agree to trade on the difference in the value of an asset between the level at which the contract opens and the level at which it closes. One of the biggest benefits of CFD trading is that you can invest in price movement both ways, and the profit or loss depends on how accurate your forecast is.
The following sections explain some of the main uses and characteristics of contracts for difference:
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Go Long or Go Short
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Leverage
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Margin
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Coverage
Long and short trading with CFDs
CFD trading allows you to invest in price movements in both directions. You can trade in a standard way, generating a profit when market prices rise, and you can also open a short position with CFDs, which will generate a profit when the price of the underlying market falls. This is called selling or going short, as opposed to buying or going long.
If you think the ABBVIE (Pharmaceutical Research and Development) share price is going to fall, for example, you could sell a CFD on the company's shares. You'll still trade on the price difference between the opening and closing level, but you'll make a profit if the stock price goes down and a loss if the price goes up.
In both types of trades, short or long, profits and losses will only be realized when the position is closed.
CFD Leverage: Increase Your Capital Cautiously
CFD trading is leveraged, which means you can get more exposure without having to pay the full cost of the position from the start. Let's say you want to open a position equivalent to 500 shares of Apple stock. With a standard trade, you would have to pay the full cost of the shares. However, with a CFD you could trade by depositing 20% of the total cost.
Leverage in CFDs allows you to increase your capital, but it is important to note that the profit or loss will still be calculated based on the full size of your position. In the example above, it would be the difference in the price of 500 shares of Apple stock from the time you opened your position to the time you closed it. This means that the profits can be multiplied, but so can your losses, which could exceed your initial deposit. For this reason, it's important to pay attention to your leverage ratio and make sure you're trading within your means.
CFD Margin: Margin trading to expand your possibilities
Leveraged trading is sometimes referred to as "margin trading" as the funds required to open and maintain a position (i.e. margin) are only a portion of its total size.
There are two types of margins in CFD trading. Margin as a deposit is required to open a position, while a maintenance margin may be required if your trade approaches losses that cannot be covered by your initial deposit and any additional funds you may have in your CFD account. If this happens, you may receive a margin call from your provider asking you to deposit more funds into your account. If you do not provide sufficient funds, your position may be closed and the losses incurred will be realized.
CFD Hedging: Reduce Risk and Protect Your Investments
CFDs can also be used as a hedge against losses on other open positions.
For example, if you think that the shares of ABC Limited in your portfolio may suffer a drop in value in the short term in response to, for example, lower-than-expected company earnings, you could offset some of the potential loss by going short the market with a CFD trade. If you were to decide to minimise your risk with such a hedging trade, any fall in the value of the ABC Limited shares in your portfolio would be offset by a profit on your short CFD position.
How CFDs Work: Fundamental Concepts and Profit/Loss Calculation
Now that you understand what contracts for difference are, it's time to take a look at how CFDs work. In this section we are going to explain four of the fundamental concepts in CFD trading: spreads, trade size, duration and profit/loss.
- Spread & Commission
CFD prices are represented by two prices: the buy price and the sell price.
The ask price (or bid price) is the price at which you can open a CFD short.
The bid price is the price at which you can open a long CFD.
Selling prices will always be slightly lower than the actual market price, while buying prices will be slightly higher. The difference between the two prices is known as the spread.
In most cases, the cost to open a CFD position is covered by the spread, which means that the buy and sell prices will be adjusted to reflect the cost of the trade.
The exception to this is share CFDs, which do not carry an associated spread as a cost. Instead, our buy and sell prices are the same as the underlying market prices and the cost of opening a position in this product is based on a commission. By using a commission, the act of investing in the price of a share through a CFD is similar to traditional share trading.
2. Size of the trade
CFDs are traded on standard contracts (lots). The size of a single contract varies depending on the underlying asset being invested in, often replicating the way that asset behaves in the market.
Silver, for example, is traded on commodity exchanges in lots of 5000 troy ounces, so the equivalent CFD contract is also worth 5000 troy ounces. In share CFDs, the size of the contract is usually equivalent to one share of the company you invest in. To open a position that replicates the purchase of 500 BBVA shares, you would have to buy 500 CFDs on BBVA.
This is another reason why CFD trading is closer to traditional trading than other derivative products.
3. Duration
Most CFD trades do not have a fixed expiry date, but are closed when you make another trade in the opposite direction to the one you opened. A buy position on 500 gold contracts, for example, will be closed by selling 500 gold contracts.
If you hold an open CFD position at the end of the day, you will be charged an overnight financing fee (16:00 Chicago time, although it may vary in other international markets). This amount reflects the cost of the capital we have lent you to enable you to open a leveraged trade.
However, there is one exception: forward contracts. A forward (future) contract has an expiration date at some later time and includes in the spread all overnight financing costs.
4. Profit and Loss
To calculate the profit and loss made on a CFD trade, you need to multiply the position size (number of contracts) by the value of each contract (in points of movement). Then, multiply that number by the difference in points between the opening price and the closing price of your contract.
Profit or Loss = (No. of Contracts x Value of Each Contract )x (Closing Price - Open Price)
To calculate the total profit or loss of a trade, you must also subtract any costs or fees applied, such as overnight funding costs, commissions, or guaranteed stop premiums.
Suppose, for example, that you buy 50 contracts on an index when the purchase price is 7500. One contract equals $10 per point, so every 1-point upward move you'll make a profit of $500, and every time the price drops 1 point, you'll lose $500 (50 contracts x $10).
If you sell your contracts when the price is at 7505, your profit would be 2500 USD
2500 = (50 x 10) x (7505 - 7500)
If you sell your contracts when the price is at 7497, your loss would be 1500 USD
-1500 = (50 x 10) x (7497 - 7500)
In short, CFD (Contracts for Difference) trading is a form of investment that allows you to speculate on the price movement of a wide range of financial assets without physically owning them. With CFDs, you can trade short or long, which means you can profit from both price rises and falls. You can also leverage to increase your exposure to the market with a fraction of the required capital.
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