The purpose of this article is to explain how contracts for difference (Or CFDs) work, and the terms associated with this type of trading. This article will provide a detailed explanation of CFDs, as well as, the main reason why people trade with CFDs, the risks associated with CFD trading, and more!
What Is A CFD?
CFD stands for ‘Contract for Difference’. A CFD is basically an agreement to exchange the difference in the value of a particular asset, from the time the contract is opened, until the time at which it is closed. What is interesting to note is that with a CFD, you never really own the particular asset or instrument you have chosen to trade, but you can still benefit if the market moves in your direction. Technically, this is because a CFD is a so-called ‘derivative product’, meaning that it has a value primarily based on an underlying asset.
If you want to trade with CFDs, there are a lot of brokers that can accommodate you, and they have trading different platforms designed especially for CFD trading.
The Way CFD Trading Works
By trading with CFDs, you can potentially profit if a market moves either up or down. If you strongly believe that an asset’s price is going to rise, you would then open a buy position, which is often referred to as ‘going long’. Conversely, if you think that the asset’s price is going to fall, then you would open a sell position, which is referred to as ‘going short’. The actual performance of the market doesn’t just govern whether you make profit/loss, but also how much.
For example, if you think a specific market will rise, you would purchase a CFD in order to trade it. Your profit will be considerably greater the further the market rises, and your losses will be greater the further it declines. The converse rule applies if you back a market to fail, so you will make more the further the market drops, and lose more the further the market rises.
It is no secret that with different brokers you can trade CFDs on a huge range of markets, incorporating indices, shares, Forex, commodities, and much more. For instance, trading a share CFD is in many ways quite similar to traditional share trading, but with extra advantages in terms of cost and convenience. You can also trade markets like stock indices through CFDs, which are not accessible to trade directly. You should take into consideration that CFDs are a
leveraged product, and can result in losses that may surpass your initial deposit on your CFD trading account.
Calculating Profit and Loss in CFD Trading
Let’s take a look at the buy and sell price. We would like to exemplify a two-way price on each market, in the same way, that you would see in the underlying market. First of all, this encompasses the bid price (which is the first to be given) and the offer price (which is the second to be given).
The difference between those prices is known as the spread. If you believe that a market is set to rise, you would buy at the offer (or higher) price, and if you believe the market is set to fall, you would sell at the bid (or lower) price.
How do you calculate profit and loss on your CFD account?
It’s actually very simple. The number of shares (or contracts in our case) you select to trade is completely up to you, as long as you meet the minimum size permitted for any specific market. You must remember that the value of one contract varies for different markets. For example, one contract for the FTSE 100 is worth ?10 per each point of movement, in the underlying index.
Therefore, if you are going long on one contract on the FTSE 100, and the index rises by one point, that would result in a ?10 profit for you. In the same manner, let’s presume that one full contract of the EUR/USD currency pair is worth $10 per each point of movement in that FX pair. If you are going short on one contract on the EUR/USD currency pair, and the price rises by one point, it would end up as a $10 loss for you.
Most CFD trades do not expire. If you wish to close out a position, you would simply place a trade identical in value in the opposite direction. Let’s use an example: Imagine that you have bought 100 shares of BP as a CFD. The price begins to fall so you decide that you would rather close the position before losing too much. In order to do that, you would sell 100 BP shares as a CFD. Of course, it is not always like that, and there are a lot of exceptions. Some brokers may offer forward contracts on different commodities, which expire at particular dates in the future.
Knowing that this is important will help you to better understand online CFD trading. That being said, you do not have to wait until the expiry date to be released from your forward contract – as you can trade out at any given time. There is no supplemental funding needed for forwarding contracts because the value is priced into the spread.