In the financial market, CFD is a contract for difference. It is used as a derivative instrument. It allows traders to trade on price movements of multiple underlying assets such as commodities, indices, and stocks simultaneously with only one trade. Trading CFDs open up an investment opportunity for those who want to speculate on the price movement of an asset class without actually owning the asset.
CFD trading is becoming increasingly popular with advanced traders, and most trading platforms offer CFD trading to their customers. Because the potential risk in CFD trading is high, traders must understand how it works and develop strategies to mitigate their risk exposure.
But how do you trade an asset without owning it? Keep reading to understand what CFD Trading is.
What is Contracts for Difference (CFD) Trading?
CFD trading is a derivative form of trading that allows traders to trade on the asset’s price movement without actually owning the underlying instrument. When you trade CFDs, you agree to exchange the underlying asset’s price difference from when you open the contract to when you close it.
One of the key benefits of CFD trading is that traders can speculate on the underlying asset’s price movements in both directions. Therefore, a trader can profit when the price moves up or down, provided the forecast is correct.
Long and Short CFD Trading
CFD trading allows traders to speculate on price movements either up or down. Therefore, you can mimic the traditional trade where traders profit when asset prices move up, referred to as going long. Alternatively, you can open a trade position that allows you to profit when asset prices fall, known as going short.
Both the long and short trade positions will realize their profit or loss once a trader closes the position.
For example, if you speculate that the price of ABC Ltd will rise, you can buy a share CFD on the company. You will exchange the share price difference between when you open the position to when you close it. If the price rises, you will earn a profit.
On the contrary, you will sell a share CFD on ABC ltd if you think its share price will fall. In this case, you benefit if the price of the shares falls.
Leverage in CFD Trading
CFD traders can use leverage, which allows them to open a large trade position without committing the full cost at the onset.
Let’s say you want to open a trade position equivalent to 1000 ABC shares. In a standard trade, you will need to pay the total cost of 1000 shares upfront. However, you only pay 5, 10, or 20 percent with a CFD, depending on the leverage ratio.
Though leverage allows you to use a small amount of capital to open a large trade position, your profit or loss will be calculated based on the full size of your trade position. The benefit of leverage means that your profit will be hugely magnified compared to your capital outlay. However, losses will also be hugely magnified if the trade doesn’t go as per your speculation.
Traders must keep in mind that leverage is a double-edged sword. While it hugely magnifies profits, it also magnifies losses if the market moves in the opposite direction. Such a huge loss could exceed your deposits.
Understanding Margin in CFD Trading
Leveraged trading is also known as ‘trading on margin.’ Traders can open and maintain a trade position with only a margin, which is a fraction of the total trade’s position. There are two types of margins in CFD trading; deposit and maintenance margins.
A deposit margin is needed to open a trade position. However, your provider may need a maintenance margin if your trade position doesn’t go your way and gets close to incurring losses. The maintenance margin covers that part of the loss that your deposit margin and any other funds in your account cannot cover.
If a maintenance margin is required, you will get a margin call, asking you to increase the funds in your account. The position may be closed, and any losses realized if you don’t top up your account.
CDFs are complex financial instruments, which can lead to higher profits due to leverage. However, leverage can also magnify losses and leave your account without capital. Therefore, CFD traders should always risk what they can afford to lose.