What is a CFD (contract for difference) in forex?
Contracts for difference are well-recognised financial instruments and are an essential part of a trader’s portfolio. Many traders, particularly those who are just starting, struggle to comprehend the meaning, benefits, and cons of trading and investing in CFDs.
What is a CFD?
CFD stands for contracts for difference. Many investors utilise this market as a gateway to step foot into financial markets. Brokers may offer CFDs alongside various other assets like spot metals and forex commodities. A contract for difference, however, is a bit different from these asset types. A CFD derives its value from the underlying asset’s movement.
When choosing to trade a contract for difference, traders agree to engage in a deal with the broker. In this case, the trader is the buyer, while the broker is the seller. They agree to a contract speculating on an asset’s change in price. While traders analyse financial instruments, it is essential to learn the difference between traditional trading and CFDs.
The contract for difference enables traders the freedom to speculate on price movements without owning the principal asset. This is a significant advantage, as CFD trading can reduce various costs and disadvantages associated with traditional trading.
While contracts for difference have plenty of benefits, trading with margin is arguably the most sought after feature that individuals want. CFDs also let traders buy or go long if they foresee price increase and you can sell (short) if you believe there will be a decrease in prices.
How CFD’s work
You do not sell or buy the primary underlying asset in CFD trading (for example, a commodity, currency pair, or share.) Instead, you purchase or sell a variety of units for a specific instrument, depending on whether you believe prices will increase or decrease.
Here is a list of things every aspiring trader must do to start their contracts for difference trading journey:
- Open a trading account with a reliable CFD broker such as FxPro.
- Download the platform or software provided
- Select an asset that you think would be most suitable for trading
- Decide if you think the asset's price will increase or decrease.
Let’s say that the cost of Gold was fifteen hundred dollars per ounce, and you believed that it could increase. You will most likely enter your trading platform to open a “buy.” trade. Once the price goes up, it can be closed to lock in the profit. This is how CFD traders make profits on the differences between buying and selling prices.
Therefore, if you started the trade when the cost of gold was fifteen hundred dollars and closed it when it hit fifteen hundred and twenty-five, you will make a twenty-five dollar profit. (when trading a value of 1oz) On the other hand, if you believed that gold prices would fall, you could open your CFD trading platform and select the “sell” trade option. Experts also refer to this as “short trade.”
A short trade happens when someone opens a trade deal believing an asset's price is about to fall and buys back the asset or closes the trade to profit from the difference. Contracts for differences follow underlying market prices, which means that market performance is a significant determinant of your trade’s failure or success.
What do Long and Short mean in CFD Trading?
While CFDs can offer you tons of benefits, one of its most significant advantages is that it lets you trade on the short and long side. If you are new to CFDs or trading altogether, it would be best to educate yourself to ensure that you know when to trade on the short or long side. Well-rounded market knowledge works wonders for traders!
Trading long means that you are utilising a buy order for your opening trade. People also use the term “going long” to explain this in CFDs. It means you are expecting a price increase and will close your position later.
Trading short means you used a sell order to open your trade. People also refer to it as "going short." Unlike trading long, you wait for the prices to drop and then close your position.
Of course, long-trading has its pros, but short trading is also beneficial. It allows you to directly profit from decreasing prices, which is particularly tricky without using products like contracts for differences.
What is Leverage in CFD trading?
Leverage is when traders or investors are able to gain exposure to more significant positions, with lower capital. Trading with leverage such as 1:10, for example, means you will require a margin just one-tenth of the transaction size to open a position. If your account value is ten thousand euros, you could utilise this leverage to enter trades worth one hundred thousand euros.
Difference between CFD and Spread Betting
The main difference between CFD trading and spread betting is that instead of selecting a trade size in units, you specify a “stake” per point. Another difference is the way the tax works. In the UK, Spread bets do not have any charges for capital gains. On the other hand, contracts for differences can become offset during losses for issues related to tax. Traders do not need to pay a stamp duty with either financial product because they do not take the underlying asset's ownership when trading. Both CFD and spread betting allow you to go short or long. Please note that Spread Betting is only available with FxPro for UK residents and that you should seek independent tax guidance from your local tax authority, as they are subject to change.
How to calculate CFD profits
Calculating your profits in CFDs is relatively straightforward. Traders multiply the difference between the opening price and closing price of their particular position, by its size.
Here is an example to explain how it works:
You open a buy position of trade 1 lot (100k) of EUR/USD at price 1.45000 and close it at 1.45650. The difference between these two prices is 65pips (650points). This is then multiplied by the contract of difference trade size of 100,000, resulting in a profit of $650.
Remember, you will need to pay the spread and may also incur overnight funding charges.
How to start trading
Want to start trading CFDs? It is never too late to get started. The process is reasonably simple; here is what you need to do:
Create a trading account
Signing up for a trading account is simple and only takes around five minutes. You will need to provide your details, financial background information and ID document(s) and once verified you can fund your account through a variety of payment methods.
FxPro also provides CFD trading demo accounts containing virtual funds, so you can practice trading without worrying about losing real money, to build up your confidence.
Download a trading platform
There is a range of CFD trading platforms available to use, including FxPro, MT4, MT5 & cTrader. Check the platform comparison page to help decide which platform best suits your needs.
Choose your trading methodology
Whether you are a beginner or an expert, having a CFD trading strategy is vital. There are plenty of trading strategies out there and each of them has its pros and cons. Take as much time as you need to understand how each methodology works to see what suits you best. Hedging, pair trading, and news trading are arguably the most common strategies used by experts.