CFD definition and basics – CFD trading explained
What does CFD stand for?
CFD stands for Contract For Difference and it is immensely popular among traders. It is, in essence, a form of derivative trading that allows you to speculate and bet on more than just one asset’s price movement. This time you have shares, commodities, treasuries, currencies and shares to play with, along with 4 key concepts you need to learn how to control:
- 1. The Spread
- 2. Varying Size
- 3. The Duration
- 4. Financial Outcome
There is little chance of understanding how to trade CFDs without mastering these 4 notions, so let’s take them one at a time.
1. The Spread
There are 2 prices that are quoted in any contract for difference trading. One is the sell price, representing the position you open a short CFD from (I’ll explain what short means in this context) and the other is the buy price, representing the position you open a long CFD from.
The spread is the difference between those 2 prices, which is also known as market value. For a selling price of 2445 and a buying price of 2446, you have a value of 1 spread. This value of 1 also represents the cost of opening your position in the trade.
2. The varying size
Any CFD definition will state that this trading method differs according to the value of the underlying asset in question. In other words, your individual CFD trading will replicate how the asset moves on the market. It is what separates this type of trading from other trading derivatives.
Just to give you an example of how this works. Let’s say you have an asset being traded in lots of 6.000 units. The equivalent CFD will automatically have the same value. In this context, buying 600 shares translates by opening 600 CFD contracts.
3. The Duration
The key to better understanding what are CFDs in trading is to understand how they function in terms of duration. CFDs have no expiry date. You need to manually close them when you see your profits settling, by placing an opposite trade to your initial position.
Did you buy 600 contracts of asset X? You can close the trade by selling an equal amount of contracts.
4. The financial outcome
Calculating the financial plusses and minuses is both easy and important. Neglecting this aspect could get you into a lot of trouble on the long run, because this is about math and you need math to work for you not against you. The faster you get this point, the better.
And the way you do that is by multiplying your number of contracts by the value of each contract. Then the final step would be to again multiply the result by the points coming out as the difference between a sell and a buy.
Let me detail on that a bit for the newbies: You have 600 contracts, trading at 600 points for each share. This means that you have 1 contract equal to 1 share. As the asset goes up, each point taken will give you £6 as profit.
Margin and leverage? – What are those?
There is no way you haven’t heard about margin or leverage. And there is no way to skip this part of the article, because I cannot accurately answer the “What is CFD trading?” question without allowing you this useful insight in 2 of the most important trading notions there are.
The definition is simple. The margin represents your initial deposit, needed to place a trade. You will be automatically charged with a specific amount of cash (the margin) for every trade you place, aside from the commission itself. This usually confuses beginners, who think “margin” is just a fancy word for fee.
Obviously, that is false, because once your trading position is closed, the margin that has been deducted from you will be immediately returned to your account. There are no standard margin requirements you need to keep in mind. This aspect depends entirely on the market you decide to activate in.
However, and this is an important addition, you have to pay attention to the margin’s value. The higher the margin requirement is, the bigger the risks become. Which, I believe, comes natural.
Another key notion to remember is the margin close out. The margin close out refers to the event where your funds equal or drop below the value of a given open position. When that occurs, you risk all your positions being automatically closed, to protect you from snowballing downstream.
This is bad, however you would look at it. This is why you need to keep your eye on the Margin Level indicator at all times, or your broker will do that for you.
The definition of leverage is even simpler than that of margin. In everyday words, the leverage is the ability to play with a large amount of cash without betting any of your actual funds. Or very little of them. You simply borrow the rest from the broker and the amount you get depends on the type of trade, on the market you operate in and on the broker’s policies.
It is easy. If you want to control a £100,000 position, you will only use £1,000 from your personal funds to do that. This is what you call a 100:1 leverage, because you are controlling an amount of money with 100 times less investment. If the position you are betting on goes up to £101,000, you will have doubled your investment.
The bad thing is that it goes both ways, making leverage a risky method, especially when you don’t know how to play it.
How does CFD trading work?
Although the basics are easy to understand, mastering them and evolving beyond the mere trial-and-error is harder than it seems. What most people are interested in is, mainly: what are CFDs in trading and why should I choose this trading method over anything else?
In this regard, I have to mention that Contract for Difference trading is gaining more popularity among traders all over the world for several reasons:
– Direct Market Access (DMA)
What this means is that, depending on which provider you decide to work with, you may be allowed to use equity exchanges on a global scale. This will provide you with plenty of trading markets to juggle with. Trust me, more options is always better, because you never know which will eventually pay off for you. You will also have the opportunity to choose what suits you best.
– No taboos
Here is where it gets interesting. Traditional trading only focuses on fit and powerful markets, where the assets’ movements are active and mainly positive. What is CFD trading in this context, you might ask? CFD trading, in this context, translates by ignoring the taboos.
In CFD trading there is no such thing as dead markets. You can gain profits from a falling market just as easy as you can from the more active, rising ones. It is one of the main reasons why traders tend to focus on this aspect in particular.
– Short-term trades
Not everybody has the financial boost to get rich overnight. And I would definitely advise you to avoid this seductive, but destructive idea. It is always smarter to start low and grow from there than start big and fall big. And, in most cases, irreversible.
CFDs market allows you to play safe and focus on short-term market trades, avoiding large investments that could ruin you in the blink of an eye. This financial safety option is what has attracted the most beginners I have seen and for good reasons.
– No market closure
The CFD markets are open around the clock. Aside from that, there are no strict time limits for the actual trading itself. One trade will only close when you wish it to close, giving you full control of the process. Compare that to traditional markets, which open and close at certain hours, only allowing you a strict timeframe to exploit the market’s volatility and you can see why CFDs are so appealing to so many.
It is quite simple in my book – Give me a higher degree of control and I am sold.
We want faster trades, fast asset movements and faster results. This is where CFD trading truly shines. You no longer have to wait for an elusive and potentially scary outcome. Now you can go for flash-trades, delivering almost instant gains, provided that you have played your cards right.
What is CFD trading going to be like for a beginner?
Scary. It will definitely be scary, that much I can say. But here is the deal. Compared to traditional trading options, the CFD market is more malleable, in the sense that you get more options to choose from, the markets are non-stop, allowing you to focus on specific timeframes and you get a higher degree of control.
For a beginner, CFD trading is probably the best starting point. Go for low investments, always remain in control and do your homework. I am giving you this from my own experience. The hardest part about the trading is going over 2 thresholds:
- Accumulating enough know-how
- Accumulating enough experience and intuition
I am here to help you with the first point, but the second one is entirely up to you. Go for it!