What is CFD trading?

What is CFD trading?
What is CFD trading?

What is contract for difference (CFD)?

A CFD contract, contract for difference, is a contract concluded between a buyer and a seller, in which the buyer must pay the seller the difference between the current price of the traded asset and its price at the maturity of the contract. A contract for difference allows traders to profit from price changes in the market without buying an asset. The value of a contract for difference does not depend on the fundamental value of the asset, and its price is equal to the price difference of the asset between entry and exit points.

In most forex brokers, traders trade using CFD contracts. When trading in a forex broker, you do not own the assets you trade, but only have the opportunity to invest in them and profit from their price changes over time. Trading CFD contracts provides major benefits to users, which has made it popular among investors. In the rest of this article, we will point out the benefits of this contract, and describe its features.

How CFD works

A contract for difference (CFD) is an agreement between an investor and a forex broker. This contract obliges the buyer to pay the difference in the price of the traded property between entry and exit.

This financial instrument is an advanced trading strategy used only by experienced traders. When trading CFD contracts, no product is physically traded. A CFD investor will never own the assets it trades. Instead, these investors can profit from the price changes of that asset over time. For example, instead of buying and selling a commodity like gold, a trader can simply swing the gold market, and profit from its price changes in the market.

Basically, investors can buy or sell an asset using CFD contracts to profit from its price changes. For example, if a trader believes that the price of an asset will rise, he can buy it using a contract for difference. On the other hand, if the trader predicts that the price of the asset will decrease, he can sell it using a contract for difference. At the time the CFD contract is closed, if the trader is able to make a profit from the price changes, he will receive an amount, but if he has suffered a loss, the amount of the loss will be deducted from his balance.

Countries which offer CFD

It is not possible to trade contracts for difference in the United States. Trading this type of contract in over the counter markets is possible in major commercial countries such as England, Germany, Switzerland, Singapore, Spain, France, South Africa, Canada, New Zealand, Hong Kong, Sweden, Norway, Italy, Thailand, Belgium, Denmark and The Netherlands.

While the trading of CFDs is currently possible in Australia, the Australian Securities and Investments Commission has announced that it has established rules in the area of ​​offering such financial instruments to retail traders. ASIC aims to protect small and inexperienced traders by reducing the leverage provided in CFDs. In the United States of America, the U.S. Securities and Exchange Commission has prohibited American citizens from trading this financial instrument, but non-American residents can still trade CFD contracts.

CFD costs

The cost of trading CFD includes commission, spread and other costs. The spread is the difference between the buying and selling price of an asset at the time the contract starts.

Usually, traders do not have to pay a commission for trading in Forex and commodities. However, brokers usually charge investors a commission for trading stocks. For example, CMC Markets, a forex broker in the UK, charges investors a commission of 0.1% or $0.02 for trading US and Canadian stocks. Opening and closing trades are considered a trade each, so buying and selling a stock involves paying twice the commission.

If your position is long-term, you will have to pay additional fees for trading CFD contracts. If you decide to keep your trade open for more than one day, you must pay the swap rate for each night you keep your trade open. The swap rate is the interest rate of currencies that traders trade in the foreign exchange market.

For example, suppose a trader wants to buy shares of a company using a CFD contract. In this case, this investor would make a trade worth £10,000. The current share price of this company is 23.5 pounds per share. The investor expects the price of this stock to increase to 24.8 pounds.

Now the trader must pay 0.1% commission to start the transaction and 0.1% to complete it. Also, if this trader wants to hold this position for a long period of time, he has to pay the swap rate as well.

Let's say this investor bought 426 shares at £23.50, bringing the total value to £10,011. Now suppose that the share price of the company rises to 24.8 pounds over 16 days. In this case, the opening price of the contract is equal to 10,011 pounds, while the closing price is equal to 10,564 pounds. The investor's profit (excluding commissions and other expenses) is equal to 553.8 pounds.

Since the commission rate for opening this transaction is 0.1%, it costs £10. Assume that the interest rate of the base currency used by the investor is also equal to 7.5%, which must be paid for 16 days. This amount is equal to £32.89 for 16 days. Also, this trader has to pay another 0.1% commission to close his trade, which is equal to 10 pounds. After deducting the transaction costs, the investor's final profit from this transaction is equal to 500.91 pounds.

CFD advantages

1. Excess leverage

CFD contracts offer more leverage than other kinds of trades. The standard leverage in this market is determined according to the laws of each country. The maximum leverage amount was once equal to 1:50 (requires 2% margin), while now it is limited to 1:30 (requires 3% margin). The lower the margin requirement, the lower the initial capital requirement. However, as the amount of leverage increases, so does the amount of potential loss. For this reason, it is essential that you follow your own risk management criteria when using leverage.

2. Global access to all markets through one platform

Many CFD brokers offer products covering major global financial markets. In this case, it is possible for traders to trade at any time and earn profit from their trades. It is also possible for investors to participate in several financial markets by trading CFD contracts.

3. The possibility of selling assets

Some markets have rules that do not allow traders to sell assets, and to do so the trader must borrow the financial instrument. Also, the margin requirement in sales transactions may be different. CFD contracts do not have such restrictions and can be utilized to sell assets without any additional costs.

4. Professional implementation at no cost

CFD brokers provide users with many custom orders such as stop orders, limit orders, etc. Some brokers also guarantee the execution of stop orders, which includes an additional fee.

Forex brokers earn money by receiving spreads from traders. Sometimes brokers also charge commission or other fees. Traders must pay the purchase price to buy an asset and use the sell price to sell it. The difference between the buying and selling prices can be small or large according to the market fluctuations. Some forex brokers offer fixed spreads, while others offer variable spreads.

5. The possibility of daily transactions

Some financial markets offer users the possibility of doing daily transactions in exchange for depositing some initial capital. But in the CFD market there is no such restriction, and all trading account holders can engage in day trading without any restrictions. Trading accounts can be opened by paying $1,000, $2,000, or $3,000.

6. Various trading opportunities

Currently, brokers have made it possible to trade in stock, index, bond, currency and commodity markets using CFD contracts. This feature has made it possible for traders in any market to speculate without going to an exchange to carry out their transactions.

CFD disadvantages

1. Spread payment

Although CFDs offer many advantages over the traditional style of trading, they also have some disadvantages. The first drawback to CFDs is that traders must pay spreads when entering and exiting trades. Paying spread rate reduces the possibility of profiting from small price changes. If your trade is profitable, paying the spread will reduce your profit, and if you have suffered loss, the spread will add to the amount of the loss incurred. Therefore, while brokers earn money in traditional markets by receiving commissions, this is done in the CFD market by receiving spreads.

2. Weak legislation

The CFD trading industry is not well regulated. The credibility of a CFD broker is determined by factors such as reputation and the financial instruments they offer. Currently, there are reputable CFD brokers around the world which you can use their services to participate in various financial markets.

3. Risks

CFD trading requires close monitoring. For this reason, traders should be aware of the major risks that they face during such transactions. Liquidity and margin risks are the main risks that traders should pay attention to. If you can't provide the security required by your forex broker, the broker will be forced to close your positions at the time of loss. In this case, you will also have to accept the loss.

In addition to increasing your profit from trading, using leverage can also increase possible losses. While many forex brokers allow users to use a stop loss order, they cannot guarantee that no losses will be imposed on traders, especially if the market is closed or the price changes in the market are extreme. The risk of executing transactions is also one of the serious risks in the CFD market. Your transaction may not be executed at the specified price. In this case, your transaction has suffered slippage.

Example of a CFD trade

Suppose the purchase price of one share in the stock market is $25.26 and a trader buys 100 shares. The value of this transaction is $2526 (plus fees). If 1:2 leverage is used, this transaction needs at least $1,263 of capital, and if 1:20 leverage is used, $126.30 of capital is required.

A CFD trade shows a loss equal to the spread when the trade is opened. If the spread is equal to 0.05 dollars, to compensate this loss, the price of this stock must increase by 0.05 dollars in the stock market. If you had bought the stock in real terms, you would have received a profit after the price increased by $0.05. However, if you buy shares, you have to pay the commission fee to the exchange.

If the price of this stock rises to $25.76 on a stock exchange, it can be sold with $50 profit, making a total profit of 3.95%. However, when the price of such shares in the central exchange reaches this price, the selling price in the CFD broker will be only $25.74. The profit from the CFD trade will be less, because the user will have to exit the trade at the selling price, in which case he will have to pay the spread.

In this example, the CFD trader earns something like $48, which is a 38% return on the initial capital invested. CFD brokers may also sell an asset at a higher price than the market price. However, the CFD trade of this stock made a profit of around $46-48, while the profit from the stock market trade was $50. But the fees that have to be paid for trading in the stock market cause the profit earned from trading CFD contracts to be higher than the that of the stock market.

Bottom line

The advantages of the CFD contract include the possibility of using high leverage, easy access to global markets, the possibility of selling assets and the possibility of speculating in bearish markets. However, the use of high leverage can also increase the amount of potential loss, and also paying spreads makes it impossible to profit from small market changes. For this reason, the European Securities and Exchange Commission (ESMA) has imposed restrictions in this field in order to protect retail traders in this market.

Written by: Mohsen Mohseni (Aron Groups).
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