What is CFD Trading?
A contract for difference (CFD) is a financial contract that pays the differences in the settlement price between the open and closing trades. There is no ownership of the asset.
What are CFD’s.
As the name implies it is a contract between the trader and the counterparty or broker. The contract is not like futures it does not have a time limit. It is a contract that pays the trader a profit if they win and pays the broker if they lose. It is essentially betting and so the regulators get involved.
CFD’s allow traders to trade in the price movement of securities and derivatives. Derivatives are financial investments that are derived from an underlying asset such as Forex and Commodities, but they can also include ETF’s, Indices, Cryptocurrencies and Stocks. Essentially, CFDs are used by traders to make price bets as to whether the price of the underlying asset or security will rise or fall.
The contract is what is called an Over-The-Counter transaction or OTC. This means there is no central exchange like the NYSE (New York Stock Exchange), instead the contracts are organized and managed by a broker network. As such this sector is largely unregulated, so there is inherent risk right from the start. We will be writing about FX Scams in the near future to enable you to steer clear and identify unscrupulous brokers generally found offshore.
Leverage in CFD Trading.
CFD trading is leveraged, which means you can gain exposure to a large position without having to commit the full cost at the outset, such as when you buy the underlying asset.
Say you wanted to open a position equivalent to 500 Apple shares. With a standard trade, that would mean paying the full cost of the shares upfront. With a contract for difference, on the other hand, you might only have to put up 5% of the cost.
While leverage enables you to spread your capital further, it is important to keep in mind that your profit or loss will still be calculated on the full size of your position. In our example, that would be the difference in the price of 500 Apple shares from the point you opened the trade to the point you closed it. That means both profits and losses can be hugely magnified compared to your outlay, and that losses can exceed deposits.Â
Margin in CFD Trading.
Leveraged trading is sometimes referred to as ‘trading on margin’ because the funds required to open and maintain a position – the ‘margin’ – represent only a fraction of its total size.
When trading CFDs, there are two types of margin. A deposit margin is required to open a position, while a maintenance margin may be required if your trade gets close to incurring losses that the deposit margin – and any additional funds in your account – will not cover. If this happens, you may get a margin call from your provider asking you to top up the funds in your account. If you don’t add sufficient funds, the position may be closed and any losses incurred will be realised.
How do CFD’s Work.
Spreads and Commissions.
Your counterparty is providing the leverage and also a service so they are going to charge a fee. This comes in one or both forms, the spread and or the commission.
The broker provides the prices that you can buy and sell at.
The offer price or buy price is the price you enter the contract with if you are going long.
The bid price or the sell price is the price you enter the contract with if you are going short.
Sell prices will always be slightly lower than the current market price, and buy prices will be slightly higher. The difference between the two prices is referred to as the spread.
Brokers or counterparties can you use spreads or commissions or both to obtain a profit from all transactions. They can add their transaction fee into the spread and the spread widens or they can add a commission on entry and/or exit of the trade.
Trade Size.
When you trade stocks for example you are buying the shares in the asset. For CFD’s you entering a contract, so you are trading in contracts.
CFDs are traded in standardized contracts (lots). The size of an individual contract varies depending on the underlying asset being traded, often mimicking how that asset is traded on the market.
Silver, for example, is traded on commodity exchanges in lots of 5000 troy ounces, and its equivalent contract for difference also has a value of 5000 troy ounces. For share CFDs, the contract size is usually representative of one share in the company you are trading. To open a position that mimics buying 500 shares of HSBC, you’d buy 500 HSBC CFD contracts.
This is another way in which CFD trading is more similar to traditional trading than other derivatives, such as options.
Contract Length.
In general CFD trades have no fixed expiry – unlike options or futures. Instead, a position is closed by placing a trade in the opposite direction to the one that opened it. That is if you buy (or go long) you then sell to exit the trade, or conversely if you sell (or go short) you then buy back to exit the trade.
If you keep a CFD position open past the daily settlement time at 5pm EST in the US, you will be charged an overnight funding charge. The cost reflects the cost of the capital your provider has in effect lent you in order to open a leveraged trade.
How To Trade CFDs.
An example.
A trader opens a brokerage account with their chosen broker. Having carried out their research using the formula
Market Driver + Technical Analysis + Risk Management + Trade Execution
they decide they want to buy the SPY (S&P 500), which is an ETF (Exchange Traded Fund of the) of that tracks the S&P500 index. The broker will provide you with leverage and will require in this example 5% deposit.
The trader wants to buy 100 shares (remember he wont own the shares its just a CFD) of the SPY at $250 per Share. This would equate to $25,000. The deposit required by the broker is 5% so the trader will need to deposit $1,250 into their brokerage account before making the trade.
The SPY moves up to $300 per share and the trader decides they want to sell to realize their profit. This trade provides the trader with $50 per share of profit which equates to $50 x 100 shares = $5,000 of profit. This is settled by the broker and they deposit into the traders brokerage account.
Here’s the reason why CFD’s can be so powerful
Return On Investment
ROI = (Net Return on Investment/Cost Of Investment) X 100%
In this example:
ROI = ($5000-$1250/$1250)x100= 300%
Thats a whopping 300% ROI.Â
However if the trade went against the trader they would only lose the deposited monies and the figure wouldn’t look so go. So you can see you need to ensure the majority of your trades must win.
Frequently Asked Questions.
Especially created for CFD Trading.
In short the answer is yes. However some regulatory authorities in certain countries have banned their residents from trading Over The Counter or OTC derivatives. One of those countries being the US.