A contract for difference (CFD) is a financial derivative that enables traders to buy and invest in assets without owning them directly. Some of these assets are stocks, indices, currencies, commodities, and exchange-traded funds (ETFs). These CFDs have a similar price to the real asset in the financial market.
For example, with CFDs, you can invest in crude oil without owning the real crude oil. Similarly, you can invest in Bitcoin without owning a bitcoin wallet or buying the real coins. The profit or loss in a CFD transaction is calculated by looking at the entry price, nature of the deal, and the closing price. For example, if you buy a stock at $10 and close the deal at $15, your profit will be $5.
CFDs have been in use since the late 1990s and have helped bridge the gap between professional traders in big institutions with small retail traders.
How to trade CFDs
There are several steps you need to follow when trading CFDs. If you are a new trader, we recommend doing several preliminary steps. These include finding a reputable and well-regulated online trading broker, learning how trading works, and creating a strategy using a demo account.
After doing all this, you need to deposit funds into your trading account and move it to the trading platform. Among the most popular trading platforms are MetaTrader 4, MetaTrader 5, and cTrader.
Finally, you should select your preferred asset, conduct your analysis, and initiate your trade. In most cases, you can conduct three types of analysis: fundamental, technical, and price action. In fundamental analysis, you look at items like news, valuation, and economic data to initiate the trade.
On the other hand, technical analysis is the process of using mathematical tools to predict the future direction of the CFD. Among the popular technical tools you can use are simple moving averages and the relative strength index. In price action, you look at the charts, identify patterns, and predict where the price will move.
After conducting your analysis, you can then open and monitor the trade. In CFD, you can either buy the asset if you believe that the price will move up. You can also sell – or short – it if you expect the price will fall. The final step in CFD trading is to close the trade and analyze the outcome.
Pros and cons of CFD trading
Pros of CFD trading
- Multidirectional – With CFDs, you can benefit when the price of an asset rises, and when it is falling.
- Leverage – With leverage, you can trade assets using more money than you have in your account.
- Multi-assets – CFD brokers provide multiple assets like stocks, commodities, and currencies in one platform.
- Accessibility – With CFDs, traders in different countries can access assets that are not available in their home countries. For example, a trader in the UK can trade American shares like Amazon and Google.
- Easy to start – Trading in CFDs is relatively easy. Indeed, it is possible to create an account and start trading within less than an hour.
- Multi-platform – Most CFD brokers have tools that enable trading through desktop and mobile devices.
Cons of CFD trading
- Leverage is risky – While leverage is a good thing, it can also be risky to most traders. Indeed, for brokers without negative balance protection, it is possible to lose more money than you invested.
- Slippage – This is where the order is executed at a different price than the one you selected.
- Overnight fees – Some brokers charge a fee for trades that are left open overnight. Although these fees are not much, they can add up in time.
- Lack of ownership – CFDs are mostly about prices and not the underlying asset. Therefore, in the case of a stock, you don’t have a normal say as the real shareholders.
Charges and margins
Most CFD brokers don’t charge a commission for opening trades. Instead, they make money through a spread, which is the difference between the bid and ask prices. The bid price is the highest price which the buyer is willing to pay for an asset while the ask is the lowest price the seller is willing to part with the asset. For example, if the price quotation of Brent crude oil is 42.50/42.55, the spread is $0.05.
In most cases, CFD trading involves leverage and margin. That means that you can trade in an asset using more money than what you have. For example, if you have $1,000 and you use a 50:1 leverage, it means that you can buy assets worth $50,000.
Meanwhile, the margin is the amount of money that is required to maintain leverage. Most brokers will require a deposit margin, which is used to open a position. They will also need a maintenance margin, that is required when the trade gets close to incurring losses.
he profit and loss are calculated by multiplying the number of contracts by the value of each CFD. You then multiply the result by the difference in points between the opening and closing prices.
CFDs are popular financial assets that have decentralized the world of investing. They have enabled people in most countries to invest and trade in popular assets like stocks, ETFs, commodities, and indices. However, CFDs are also risky assets, especially when they are overleveraged. Therefore, if you are a beginner, we recommend that you take time to learn and create a trading strategy. You should also learn more about price action, fundamental, and technical analysis. Most importantly, you should craft a good risk management strategy to maximize returns while reducing risks.