What is a CFD? How do I trade CFDs?
CFD is an acronym for ‘Contracts for Difference’. The difference being the price you enter and exit the trade of a particular market.
If you were able to buy the market at a lower price than you sold – you would’ve made a profit. If not, you would’ve made a loss.
You don’t have to buy first when entering a CFD, however. You can go short (sell) first and if the market goes down in value and you buy the same market to close your existing position – You make profit. If the market you have sold initially rises – you will make a loss.
When trading CFDs you don’t actually own the underlying asset you are trading. You are strictly trading a price differential. CFDs are similar to Spread-betting (without the tax benefits if you live in the UK)
Because you don’t actually own any underlying assets when you trade a CFD – you don’t have to put up as much initial margin. Much like spread betting again – you only need to fund a % of margin as the accounts are usually ‘Leveraged’. Again because you don’t actually own the physical asset you are trading – these contracts are seen to be very flexible and popular with short-term traders.
If you’re already looking to open your trading account – please click here.
3 advantages of trading CFDs:
- The ability to trade a variety of different markets spanning many different countries and sectors
- Margin – As previously mentioned, because you don’t own the underlying asset, the amount of initial margin you need to place your trade Is much lower than a physical trade
- The ability to open a trade by going LONG or SHORT. i.e Buying or Selling as an opening trade to allow you to benefit from the market moving in both directions
3 Costs to be aware of
The cost of trading a CFD can come in many different forms. We will run you through each of the usual formats here, but please remember to check with your broker before you start trading so you know exactly what to expect when you come to place your first trade:
- Commission – Fairly self-explanatory. There may be a commission associated with each trade you place. This commission could be charged on entry, exit or on both sides of the trade
- Spread – The actual cost of trading could all be incorporated in the actual spread of the market you are trading. Usually if this is the case (like in spread betting) the spreads will be slightly wider than usual
- Financing – Financing is the charge to hold your positions overnight, usually after 10pm London time or (rollover) These charges vary from broker to broker and are completely reliant on which symbol you are trading
As we said earlier – you just need to check which of these cost options your broker is offering. We aren’t saying one is better than the other – but its always advisable to know what you are getting yourself into and to avoid any nasty surprises at a later date.
CFDs are a very popular, flexible vehicles that traders can use on a daily basis. There are enormous amounts of markets that you have access to and each of these offerings will vary from broker to broker. Here are the main markets that we see traded on the financial side of CFD Trading:
- FX (Forex)
- Stocks and Shares
- Stock Market Indices
- Commodities (Such as Coffee)
- Metals (such as Platinum)
Let’s take a look at a quick example of a CFD if we were trading a security such as a stock that has a value of 100p.
If we bought this stock at 100p and the price rose to 110p we have made 10p on the trade. Fairly simple right? But how many CFDs did we buy?
Let’s say we bought 500 CFDs. Then we take 500 and multiply by 100p = £500
We already know the stock has risen to 110p and that is where we are going to sell. So we sell – 500 contracts at 110p = £550
So you can see the benefit of trading a CFD here. The stock only needed to move 50p for me to gain a profit of £50.
Just remember that when the market goes in your favour, the leverage and use of a CFD contract is fantastic. Less margin and magnified gains. But if the market goes against you – your losses will also be magnified.
One large advantage of trading CFDs is that you don’t have to fund as much to place your trade when compared with the purchase of the physical asset. This is achieved by using leverage.
Leverage is essentially the borrowing of funds to allow a trade to be placed. Usually so you can place bigger trades without having to fund as much margin.
In turn – this means you can make more money as the movements in the market you are trading are amplified. But please be sure to keep in mind this works on the downside too. Ie –losses are also amplified.
Leverage is usually shown as a ratio. Let look at a few examples
- 100:1 (Only 1% margin is required)
- 200:1 (Only 0.5% margin is required)
Always check the leverage your broker is offering and which leverage suits your trading. Also keep in mind that leverage is an amplification of both the upside of the market but also the downside.
Margin is what you deposit into your account initially. This deposit of funds you will use to place your trades. We have previously mentioned that you don’t have to fund as much (initially) when trading CFDs as when physically buying a share because of something called leverage.
The 2 main types of margin you will need to concern yourself with are Initial and maintenance margin. Initial margin is the funds used to open the initial trade itself and maintenance margin is to fund the Profit and loss of that trade or number of trades on an ongoing basis.
You may have seen or heard the term ‘Margin Call’. These are alerts to inform you that your margin is running low and you should look to make a further deposit to your account to maintain your current positions. If you do not deposit in time or you decide against re-funding, then its fairly likely that soon you may be closed out (stopped out) of your positions.
For MT4 brokers – this is likely to be done by closing your largest losing trade initially. Then closing the next largest losing trade until your account has sufficient margin left or the account is fully closed out.
You can place various orders within the market. These are the main ones you need to concern yourself with:
- Stop Loss – Orders to cut you out of a trade at a certain point. These are used if you have a level in mind that you don’t want to hold the trade past. Or, you have a certain amount of funds you were willing to lose. This order will ensure you don’t lose any more.
- Take Profit – This order is used to close your trade when the market hits a certain price. This price is a target that you set and is often higher (or lower if you’re short) than the current trading price.
- Buy and Sell Limits – These orders enter the market at a preferential rate whether that be higher or lower (depending which direction you are trading)
- Buy and Sell Stops – These orders are executed when the market moves past certain price points on the upside or the downside.
If you’re ready to start trading CFD’s, please click here to open your account today.