Over the past few months, I have received emails asking about CFD trading and its relation to forex trading, and trading overall. Most forex traders will trade CFDs from inside their accounts, so this is my attempt at answering the most basic of questions through definition and example, so you can feel more comfortable trading this product.
What is a CFD?
CFD stands for Contract for Difference. It is essentially a contract between the trader and broker to exchange the difference in opening price and the closing price of a financial instrument, such as shares or commodities.
What is CFD trading?
This derivative product allows you to bet on the movement of the market. This makes it a useful trading option if you predict a change in the market. If you think the market price will rise, you can go long (buy). If you think prices will fall you can go short (sell).
With CFD trading, you don’t own the underlying assets, you are dealing merely with a contract. This also means you don’t have to put up the money for the instrument. Since CFDs are leveraged products, you pay just a percentage of the value of the instrument. Since your upfront capital is much less, you can make bigger trades with the potential for substantial gains. However, the risk is that you can lose considerably more money than you started with.
CFDs are particularly attractive if market prices are falling. To protect your overall investments, you can take out CFDS and go short (in other words bet that the market price will decrease). This way you can offset any losses to your portfolio from dips in the market.
An Example of a CFD Trade
Let’s say you are interested in BAT shares, as you believe it is performing well and will increase in value. The share is sitting at an asking value of $115. You decide to buy 200 BAT CFDs. The total value of the contract is $23,000.
Since you are not buying the physical shares, rather than having to pay the full value, you pay the margin requirement set for the CFD. Your broker has valued this particular share at 2%. Therefore, you need to pay $406 to open the CFD position. Since you feel BAT’s position will improve, you decide to go long.
Your predictions are correct, and the share price increases. You decide to close your position when the share price of BAT reaches $125. The price has moved 10 points in your favour. This means you have made a profit of $2,000 (200 units x 10).
Contrary to your prediction, the markets fall. You quickly close your position at $100. The price has decreased by 5 points. Your loss is $1,000 (200 units x 5). Your loss is now greater than your initial deposit.
Note that CFD trades usually have a commission charge. There may be additional holding charges, depending on whether your CFD has a fixed expiry or not.