A CFD, also known as a contract for difference, is a financial derivative financial instrument that allows traders to profit from price movements without physically owning the underlying asset. It is essentially a bet on a particular underlying asset going up or down in value, with the CFD provider and you agree that whoever wins the bet will pay the other the difference between the opening price and closing price (the asset’s price when you enter the trade and its price when you exit the trade).
Since they were first introduced to the public, these financial trading contracts have become extremely popular, largely because CFDs offer a flexible and easy-to-use form of trading. So, let’s explore CFD trading in detail and help you understand how you can make money trading CFDs.
In Forex terms, A CFD trade is an agreement to exchange the difference in the price of a currency pair underlying asset from when you open your position versus when you close it. Trading CFDs in the forex market gives you the chance to trade a currency pair in both directions without having to meet strict margin requirements, meaning you can take both long and short positions. One of the key attractions of CFD trading is the high leverage provided by CFD brokers, which typically falls between 2:1 to up to 1000:1 (depending on the asset class and the instrument).
With CFD trading, if the market moves in the direction you predicted, you profit from the price difference. If the market goes against you, you would make a loss. In practical terms, if you buy a CFD contract at $50 then sell it at $51, you will receive the $1 difference. Conversely, if you entered into a short CFD position and sold at $50 before buying back at $51, you would pay the $1 difference.
However, the main difference between CFD trading and traditional trading is that you do not physically own the underlying asset. Instead, when you trade CFDs, you simply speculate on the price of the asset with the goal of making profits.
Fun Fact: CFDs were originally traded among financial institutions, such as banks. But in recent years, they’ve become more popular with retail investors and CFD traders because they allow you to trade without having to own any securities yourself.
CFDs offer the opportunity to trade a vast array of financial markets, including stocks, indices, commodities, bonds, forex pairs, cryptocurrencies, ETFs, and more… Unlike futures contracts, CFDs don’t have an expiry date. A contract for difference is renewed at the close of each trading day and traders can keep their positions and CFD trades open indefinitely. Well, for as long as there’s enough margin in their account to support the position.
In CFDs retail investor accounts, there are also very few fees charged for trading CFDs (other than the overnight fee), and many CFD brokers don’t charge any commission or fees when entering or exiting a trade. Instead, the CFD broker makes money by having the trader pay the buy and sell spread. To buy, a trader pays the ask price, and to sell/short, the CFD trader must take the bid price. This is one of the main reasons why CFD trading has become such a popular form of trading for beginner and experienced traders.
In terms of what affects the prices of CFDs – it is essentially the price movement of the underlying assets. Keep in mind that a CFD contract is basically a derivative contract that is known as off the exchange product. In other words, this means that you are speculating the opening and closing prices in a CFD trade versus another trader or, usually, versus the CFD provider.
For example, crude oil CFD prices are mainly driven by supply and demand or by seasonality. Prices of equity CFDs can be determined by business factors or company-specific factors, such as earnings or acquisitions. Price movements in the Forex market are mostly influenced by fundamental factors, such as economic growth, inflation, interest rates, geopolitical tension, monetary policy expectations, and environmental factors.
So, when you trade CFDs, you technically need to analyze the underlying asset price, the same as when trading the chosen asset on a traditional trading platform and physically owning the underlying asset.
To better understand how CFDs work, let’s paint a picture.
Trump has been busy on Twitter, the jobs market in the US appears to be stalling and you expect the level of Non-farm Payrolls to come in below analyst’s estimates. Surely this means the US dollar will weaken and the British pound will strengthen… Time to make a CFD trade and go long (buy) 1 CFD on GBP/USD at 1.3100.
Good news, non-farm Payrolls came in even weaker than you expected! GBP/USD is now trading at 1.3180 / 1.3182 and you decide to buy to close your CFD position at 1.3180. So, you bought at 1.3100 and sold at 1.3180, a rise of 80 pits. This gives you a profit of $80.
The higher the exchange rate goes when you go long, the more money you’ll get. But here’s the catch. CFDs are leveraged trading products, which means that when you are trading CFDs, the potential of your profits is significantly higher but also the chances of losing money rapidly.
For Instance, What Would Have Happened if the Non-farm Payroll Data Had Come in Better Than You Expected?
If the US dollar would have strengthened against the pound, sending GBB/USD lower and you decided to close your CFD trade at the closing price of 1.3050, you would have lost $50.
Remember, all forms of trading involve risk. And dealing with derivatives like CFD contracts and margin trading can be even trickier for newbie traders due to the high risk of high leverage trading. But if you are planning to open a CFD trading account and trade CFDs, the smart thing to do is to take your time and develop an investment strategy that works for you. You’re on your way to expanding your trading basket and your trading skillset. Don’t rush things and make sure you complete our trading academy before you start placing any CFD trades.
Certainly, there’s a debate that revolves around the concept of CFDs. Unlike investing in the stock and futures markets, CFDs have no value rather than allowing users to speculate on prices of the underlying assets. Nonetheless, for the average Joe trader, CFD trading is much easier and flexible than trading stocks and commodities outright. In fact, it is the ideal way for traders to get access to nearly all financial markets and the most financial assets in global markets through a CFD trading account.
In comparison to other forms of trading, some of the benefits of CFD trading include low initial deposit, high leverage ratio, low trading costs, and the ability to take long and short positions without having to meet strict margin requirements. So, if you are planning to trade FX currency pairs and get access to other financial instruments and top trading platforms, CFD trading might be the best solution for you.