What are CFDs

Published by

Bastian Langston activities: ,

Jul 28, 2021

CFD stands for Contract for Difference. CFD trading has become extremely popular. It allows you to take advantage of the price variations of a wide variety of listed assets (stocks, indices, commodities, cryptocurrencies...) without having to buy them. This section will find all the information you need to know to understand how CFDs work and the possibilities that these products can offer you in your trading.


How to trade CFDs

A Contract for Difference is a contract whereby two parties agree to exchange the difference between the entry price and the exit price of the underlying asset on which the CFD has been established.

When trading CFDs, you do not buy or sell the underlying asset. When trading CFDs, you are speculating on the future direction in which the underlying assets price will move. This type of trading is done by buying and selling CFD contracts:

If, for example, you believe that Amazons share price is going to rise, you will buy CFD contracts. When you want to close the trade, you will sell those contracts. If you sell the CFDs, the share price has risen, you will make a profit proportional to this rise.

On the other hand, if, for example, you think that Teslas share price will go down, you will sell CFD contracts. When he wants to close the operation, he will give the reverse order; he will buy his sold contracts. If buying the CFDs, the share price has gone down; you will make a profit, which will provide for the price decrease.

In both cases, if the price moves against expectations, you will make a loss proportional to the price change.

CFD prices

When buying and selling CFD contracts, it is important to know the bid and ask price of the CFD. Like other financial instruments, a CFD has two prices:

- Buy price (bid)
- Ask price.

Normally, when the price of a CFD is displayed, the bid price is displayed first, and the asking price is displayed second. For example, if Apple stock CFDs are quoted at 130.95 / 131.16 (bid/ask), the purchase of these CFDs will be made at USD 130.95 (bid price) and the sale at USD 131.16 (ask price).

The difference between the two prices is called spread and corresponds to the cost you must pay to your broker for trading these instruments,

The bid and ask prices of CFD contracts are related to the price of the underlying asset. The bid price is slightly lower than the market price of the asset. On the other hand, the asking price is slightly higher than the quote.

Leverage and margin


CFDs are a leveraged product. This means that you only need to deposit a small percentage of the total trade value to open a position. This amount is called margin. Margin trading allows you to maximize your profitability, but your losses will also be multiplied as they are based on the total value of the CFD position.

The following example shows the effect of leverage and margin, as well as the profit calculation of a CFD trade:

At a given time, a contract is priced at 9,790/9,800 (bid/ask). A CFD trader thinks that the IBEX-35 will make an upward movement, so he opens a long position by buying 1 CFD contract.

Thanks to leverage, the capital required to open this position is not $9,800 but a small percentage of the position value. AvaTrade offers you a leverage of 20:1 on this product, so you would only need to deposit a margin equal to 5% of the position value. Therefore, the initial gross investment to buy 1 CFD contract would be:

9800 x 0.05 = $490.

The market responds to the traders expectation, the IBEX-35 moves upwards, and the price of the CFD is quoted at 9,900/9,910. At that moment, he decides to close the trade and sells the CFD contract.

The profit from the trade is obtained by applying a multiplier to the change in the assets price measured in points. In this case, the multiplier is EUR 10 for each point change in the Spanish index. Therefore, the formula for calculating the result of the transaction is:

(Sale price - Purchase price) x no. of contracts x 10 =.

(9,900 - 9,800) x 1x 10 = $1,000.

Without discounting the spreads, the gross result would be $1,000 for an investment of only $490.

What will determine the profit or loss in CFD trading will always be the size of the variation (either up or down) in the underlying asset price. For this reason, the CFDs that are the most profitable (and also the riskiest) are those where the volatility of the underlying asset is the highest.

Why do traders choose to trade with a CFD broker?


CFDs are one of the most widely used instruments in online trading. Moreover, its easy to start due to a huge amount of trading platforms. Some of the popular are dotbig, Binance, eToro.

These are the advantages that explain the diffusion of this type of contract:

Versatility

The number of different underlying assets on which CFDs can be bought or sold is enormous. Today it is possible to trade CFDs on:
- Commodities
- Currency pairs

This versatility facilitates access to assets with different correlations, allowing CFDs to be used in portfolio hedging strategies as protection against contrary movements in stock market CFDs.

Diversification

As indicated above, it is possible to obtain a positive return whether the underlying assets performance is bullish or bearish.

Flexibility

Unlike other derivative products such as futures, CFDs do not have an expiration date, so the position that has been opened can be closed at any time of interest to the trader, provided that there is a counterparty in the market.

Leverage

CFDs are a derivative financial product that allows trading. This means that it is possible to trade with more money than is actually available, multiplying the possible profitability and potential loss. For this reason, both profits and losses can be much greater than the amount actually invested:

For example, a has a price of $9,790/9,800. This price coincides with the price of the index. If you think that the IBEX-35 will make an upward movement, you could open a long position by buying 1 CFD contract. Thanks to leverage, the capital needed to open this position would not be $9,800 but a small percentage of it. AvaTrade offers you a leverage of 400:1, so you would only need to deposit 5% of the CFD price. Therefore, the initial investment to buy 1 CFD contract would be $490. The profit from the trade is obtained by applying a multiplier to the change in the index measured in points. In this case, the multiplier is $10 for each point. If, for example, your expectation has been met and the IBEX-35 has moved upwards, with a CFD trading at 9,900 / 9,910, and you decide to close the trade by selling the contract, the result of the trade would be:(9,900 - 9,800) x 1 x 10 = $1,000 against an investment of only $490.

Accessibility

Thanks to the possibility of leverage, access to CFD trading is certainly affordable. This is one of the main reasons that undoubtedly explain its expansion among traders with a basic availability of initial capital.

Liquidity

CFDs on stock indices, currency pairs, or shares with a high trading volume are highly liquid, which speeds up orders to open and close positions as it is easier to find a counterparty.
In short, CFD trading gives you access to major currency crosses, company shares, indices, or commodities with a widespread and allows you to control larger positions in these markets with minimal initial capital.

Tips for CFD trading

- Use a demo account. If you do not have enough knowledge and experience in financial markets, the best option is to practice as much as possible on a demo account to test your strategies without any risk.
- Short-term trading. Due to its characteristics and the cost of keeping a position open for more than one day, CFD trading is very well suited for short-term operations (day trading).
- Use technical analysis tools. Technical analysis, which is based on the study of price evolution charts, is the best suited to CFD trading. In fact, making short-term investment decisions based solely on fundamental analysis is not enough to increase the probability of success in this type of trading. Use charts to analyze the variations of the CFD you wish to trade. Each financial instrument has its own technical behavior, with patterns in the evolution of prices that are often repeated.
- Keep your emotions aside This is a fundamental point, not only for CFD trading but also for trading any other type of financial instrument. CFD trading is a rational activity that requires constant analysis and must respond to a careful strategy.
- Do not try to recover losses. As with the previous advice, this also applies to any trading, not just CFD trading. In general, the principle is simple: if you are losing money on an investment, it is better to give it up and close the trade as soon as possible. Getting into a dynamic where you quickly open trade to make up for the losses from the previous one usually leads to further losses. CFD trading is an activity that requires high doses of discipline to stay true to the designed strategy.
- Use leverage appropriately. Leverage is one of the characteristic elements of CFDs, for better or worse. Since it allows access to much greater exposure to the initial capital, it can also generate much greater losses for the money invested. For this reason, you should always monitor your losses so that they do not balloon and lead to situations that are almost impossible to hedge later on.
- Use the stop-loss order. The best option for controlling leverage is to use the stop-loss tool. This order allows you to set a price at which the trade is automatically closed. In this way, it is possible to limit the capital you put at risk on each trade and never put more money at risk than you can afford to lose.

In conclusion, CFD trading is not an emotional activity. On the contrary, it is a rational activity, based on chart analysis, patience, and, of course, discipline and perseverance to monitor your trades. In this way, you will learn from your mistakes and improve your trading strategy day by day.

Articles authored by Bastian Langston