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What is CFD trading? A beginner’s approach

What is CFD trading
Contract for difference (CFD) is a versatile financial instrument used to speculate on the price movements of several financial markets. Basically, it is a financial contract between two parties in which the price movement of an underlying asset is traded without actually owning the asset. CFD contracts are usually made between a broker and a trader; each party receives or pays the difference between the opening and closing prices of an asset at the end of a trade. CFD trading is the buying and selling of contracts for differences for the purpose of making potential profits. 

Features of CFDs

Below are a few things you should know about CFDs:

Derivative trading

CFDs are financial derivatives; this means that its prices are derived from the prices of other securities usually called ‘underlying assets’. For example, ‘Apple Inc’ is a renowned technology giant that produces iPhones, iPad, Mac computers, etc. Its equity shares are traded on the NASDAQ exchange, USA. The prices of Apple CFDs listed on brokers’ platforms are obtained from NASDAQ as the company shares are traded in real-time. So, you can only trade Apple CFDs when NASDAQ is open and in session. But with CFD trading, you are not buying or selling Apple equity shares, you are just predicting the price movements of its shares.

Similarly, if the price of gold increases, the price of Gold CFDs on the brokers’ platforms will also increase. 

Over the counter products

Unlike traditional trading of stocks and futures which are traded on regulated exchanges, CFDs are traded as over the counter (OTC) products and not on exchanges. It is simply an agreement between a trader and a broker to speculate on the price movement of selected financial instruments.

Leverage

Before you delve into trading, it is important to understand how CFDs work and how to trade CFDs using leverage. Usually expressed as a ratio, Leverage is a tool that enables CFD traders to open trade positions that are much larger than their invested capital. For example, on a leverage of 1:30; a CFD trader can open a position of 3,000 ZAR with only a balance of 100 ZAR. So, leverage has multiplied his market exposure or capital by 30. This gives more opportunities for profits but also magnifies losses as well.

Margin

This is related to leverage but expressed as a percentage. Margin is the amount of deposit required to open a larger CFD position. If a required margin of 20% is stated for an instrument, it translates to a leverage of 1:5. So, to open a trade worth 1,000 ZAR, a margin of 200 ZAR is required. Once the trade is opened, the maintenance margin is the amount of funds that must be in the trading account in order to maintain the open positions and avoid a margin call. This is a text, notification, email, etc from your broker to add more funds or close a losing position. 

Spread

CFD providers quote two prices for every asset; ask and bid price. The spread is the difference between the ask and bid prices. Most brokers embed their charges into the spread while some charge commissions for every trade. CFD traders often seek for brokers whose spreads are low in order to avoid paying high trading fees. 

Contract size

If you wish to trade CFDs, you cannot just buy or sell any volume or deal size, instead, there are standardized contract sizes often referred to as lots. For example; in forex, 1 standard lot = 100,000 units of currency. 1 standard lot of Gold = 1 troy ounce. 

CFD trading instruments

CFD traders do not own the assets they trade; rather they only try to profit from the fluctuating prices of the underlying asset of interest. So, the securities traded in most financial markets are available as CFDs. Below are some of them:

Stocks

The stock market is a marketplace where the equity shares of the big companies are traded in various stock exchanges. The New York Stock Exchange (NYSE) is the largest stock exchange in the world with a market capitalization of about $26.2 trillion.

Stock CFDs are contracts that allow traders to predict the price direction of company stocks as they are traded on the exchange. A trader usually carries out his analysis on a selected company stock, predict a rise or fall in share price and then place his trades on the broker’s platform. If he is right, he makes potential profits but if he is wrong, he suffers losses. When you trade CFDs, you stand a high risk of losing money, especially when trading leveraged positions.

Stock Indices

These are statistical metrics that measure how well or how bad the stock market or some of its sectors are performing. For example, the S&P 500 index tracks the performance of 500 of the largest companies in the USA; FTSE 100 tracks the performance of 100 of the biggest companies listed on the London Stock Exchange (LSE). Index CFDs enable CFD traders to speculate on the values of underlying indices with the hope of making profits if the prediction is correct.

Commodity CFDs

Commodities are standardized agricultural goods, raw materials or natural resources. Hard commodities are mined; examples are Gold, Silver, crude oil, natural gas. Soft commodities are grown; examples are coffee, cotton, corn, wheat, etc. CFD trade in commodities means that the trader is predicting the price direction of a specified commodity within the trade time.

Cryptocurrency CFDs

Cryptocurrencies are a form of digital money that can be used to pay for goods and services. It uses blockchain technology; which is a decentralized database of records that are secured, time timed and irreversible. The most popular cryptos are Bitcoin, Ethereum, Litecoin, etc. To own and use cryptocurrencies, you will need to buy it from a crypto exchange and store it in your wallet. But, to trade cryptocurrency CFDs, no need for a wallet; instead, you simply predict if the selected crypto price will go up or down at a given time. If you are right, you make profits and if you are wrong, you lose part or all your invested capital. The underlying market is the crypto market which is made up of crypto exchanges.

Forex

Forex trading is the exchange of one currency for another. It is traded like CFDs and virtually all CFD brokers offer forex trading as well. Various national currencies are grouped into forex pairs and traded against each other. Traders speculate on the exchange rates of one currency against the other. The underlying market is the global forex market; which is currently the world’s largest market where participants from all over the world trade various national currencies on a 24/5 basis. 

Trading CFDs

If you want to trade CFDs, then, the first step is to find a CFD broker. These are financial investment firms that give their clients access to trading platforms where CFDs are traded. There are many online brokers who offer CFD trading and most times, finding the right CFD provider is a challenge to new traders. Some brokers are regulated by the authorities in their country of jurisdiction while some are not regulated. Some of the regulators are Cyprus Securities and Exchange Commission (CySEC), Financial Conduct Authority (FCA) in the UK, Financial Sector Conduct Authority (FSCA) in South Africa, etc.

Generally, when choosing a broker, check out its digital security implementations, trading fees, regulatory status, available assets, minimum deposit, payment options, trading platforms and the full range of services available before you decide to trade CFDs with this provider.

On its software trading platforms, every broker streams the buy and sell price for every available asset in real-time. The CFD trader first analyzes his underlying asset of interest and come up with a prediction if the asset’s price will increase or decline. Then, he logs into his account on the broker’s platform and do any of the following:

• Open a long position by clicking on ‘buy’
• Open a short position by clicking on ‘sell’.

You can monitor the trade in real-time and close it whenever you are satisfied with the results. On the platform, there are risk management tools to help you curb losses and also analyze the price charts. You will make potential profits if prices go in your predicted direction but will suffer losses if you are wrong. Do not forget that trading CFDs come with the high risk of losing money especially if you used leveraged trading. 

CFD trading with Investby

Investby is a reputable forex and CFD broker established with a registered address in Minsk, Belarus. It offers multiple CFD assets on its software trading platforms. Traders have a choice of trading through the following platforms:

• Investby WebTrader: This is an online platform accessible through a web browser. It comes with powerful tools for trading and analysis.

• MT4 trading platform: This is a very popular trading platform that Investby provides as windows desktop application as well as mobile apps for android and iOS devices. MT4 comes with complex analytical tools and supports automated trading using trading robots (expert advisors).

To begin CFD trading with Investby, follow the steps below:

1. The first step is to open a new trading account. To do this, click on ‘open account’.

2. The account opening form displays; it has 5 sections.

3. Complete all the sections of the form; account, information, questionnaire, documents, and deposit.

4. For documents, upload a copy of your government-issued ID card and a recent utility bill.

5. For deposits, choose the best option available to you.

6. Once your trading account is approved, you can launch the WebTrader or download the MT4.

7. Locate the assets’ quote and view the buy price and sell price of your chosen CFD asset.

8. Open a long or short CFD trade by clicking on ‘buy’ or ‘sell’. The status of the trade as well as your floating balances will be displayed in real-time.

9. You may decide to close the trade when you are satisfied.

Once the trade is closed, the contract is terminated and your account balances are updated according to the result of the trade. Do not forget that trading CFDs is a high-risk venture. You are taking the high risk of losing a significant part or all of your invested capital. There are no guarantees and even if you have succeeded in the past, it is not an indication of future successful results. 

Example of a CFD trade

To calculate the profits or losses from a CFD trade; let us demonstrate with an example.

A CFD asset A is listed with a sell price of 23.23 ZAR and a buy price of 24.02 ZAR. A trader came up with an analysis that the prices will rise, so he goes long at the opening price of 24.02 ZAR for 100 CFD units. The price rises at first but continues to fluctuate, later it declines. After a few hours, he decides that he has had enough and runs off at a closing price of 22.31 in order to curb his losses.

Loss = (Closing price - entry price) X contract size

Gross Loss = (24.02 – 22.31) X 100 = 171 ZAR

The actual loss will be obtained when the broker subtracts its charges and other fees such as swap fees which may be incurred if an open trading position was maintained overnight. 

Why trade CFDs

Go long or short

Unlike traditional trading and investment where you buy and sell later at a profit, CFD trades are different. It gives opportunities to make potential profits in both flourishing and falling markets. The principle is simple; when prices are bullish, you go long, but with falling prices, open a short position. 

Access to trade the global markets

With one CFD trading account, multiple trading opportunities are available to the trader. For example; you can trade stocks from several countries, forecast the price of Bitcoin, trade Gold, predict the price direction of coffee and do so much more, all from the same account and deposit.

Low Capital

Leverage CFD trading means using a small capital to open large trade positions. This is why many retail investor accounts are opened with paltry sums of money with the hope that profits will grow the capital. Unfortunately, most CFD providers assert that a large percentage of retail investor accounts lose money while trading CFDs.

Trade from anywhere

Trading CFDs can be a part-time or full-time profession. All that is required is an access device such as a computer, tab or Smartphone. The broker takes care of the technology, platforms and other requirements. You can open your CFD trades from anywhere which includes your home or office.  

Summary

What is CFD trading? It is the business of trading CFDs in order to make profits. Though it sounds simple and profitable, traders stand a high risk of losing part or all their invested capital. CFD trading is available through brokers who offer their services through the internet. Unlike other traditional financial instruments, CFDs are convenient, less capital intensive comes with the ability to access multiple markets, and has profit potentials even in declining markets.

Investby is a broker that offers CFDs in over 350 trading instruments which include forex, stock indices, cryptocurrencies, commodities and stocks. The broker offers tight spreads with no commissions. Client trades are executed in milliseconds and all standard digital security measures have been implemented to ensure a safe trading environment. Both professional and retail clients are welcome to trade CFDs with this provider. Traders are supported with tools for analysis and learning. The client support desk is available to assist 24/5.

FAQs

What is CFD trading and how does it work?

CFD trading is the act of buying and selling of contracts to speculate on the price direction of an underlying asset without owning it. Many online brokers provide software platforms where they display the buy and sell prices of various CFD assets. CFDs work as follows: traders open a buy position when they forecast a price increment, but open a sell position when a decline is expected. Profits or losses are calculated from the price difference between the opening and closing trade prices. 

How long can I hold a CFD?

There is no limited time to hold a CFD position; it will remain open as long as you have enough money in your CFD trading account to cover the open position. CFDs do not have expiry dates but they incur swap fees when you leave a position overnight. Generally, if you leave a trade open for some weeks, swap fees will accumulate and may cancel out any profits earned. 

Why is CFD illegal?

CFD trading is not illegal in most countries and jurisdictions. But it is banned in the USA and a few other places because of its over-the-counter nature. American regulators prefer financial securities that are traded on regulated exchanges like stocks, futures, ETFs, etc.

 
The information above is for education purposes only and cannot be considered as investment advice and past performance is not a reliable indicator of future results.
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