What are Margins in CFD trading CFD margins explained

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Contents

How to Trade CFDs

Find out more about Contract for Difference (CFD) trading with City Index.

How to place a CFD trade

With the ability to trade on falling markets, use leverage and access thousands of instruments, some trading 24 hours a day, investors are taking advantage of the versatility of CFDs as part of their portfolio.

CFD trading steps

  • Choose a market
    Decide which market you want to trade on. You can get trading inspiration through our fundamental and technical analysis research portal
  • Decide to buy or sell
    Click ‘buy’ if you think the price will increase in value or ‘sell’ if you think the market will fall in value
  • Select your trade size
    Choose how many CFDs you want to trade. 1 CFD is the equivalent of 1 physical share in equity trades
  • Add a stop loss
    A stop loss is an order to close your position out at a certain price if it moves too far against you
  • Monitor and close your trade
    Once you have placed your trade, you will see your profit/loss update in real time at the top of the screen. You can exit your trade by clicking the close trade button

CFD trading explained

Choosing a market

At City Index, we offer CFDs on thousands of individual markets including shares, indices, currencies, commodities, interest rates and bonds, allowing you instant exposure to major global markets including the UK, US, Europe, Asia, Australia and New Zealand.

With so much choice, it is important to find a trading opportunity that suits you. You can use the research tools provided on the trading platform to help you identify trading opportunities that match your trading style.

Use the search function on the platform or app to search and select your market. Learn more about our research tools here.

Decide to buy (go long) or sell (go short)

Once you have chosen a market, you need to know the current price. You can do this this by bringing up a trading ticket in the platform.

CFD markets have two prices. The first price quoted, is the sell price (the bid), and the second price is the buy price (the offer). The difference between the two is known as the spread. The price of your CFD is based on the price of the underlying instrument.

If you believe a market price will go up, you buy that market (known as going long). If you believe it will fall, you sell the market (going short).

Select your trade size

With CFD trading you select the number of CFDs you wish to trade.

With equity trades, 1 CFD is equivalent to 1 share. When trading indices, FX, commodities, bonds or interest rates, the value of 1 CFD varies depending on the instrument. You can see which number you are trading on by looking up the ‘tick value’ in the instrument’s market information sheets. CFDs are traded in the base currency of the market.

CFD trading is a leveraged product which means you only need to have a small percentage of the overall trade value, known as margin, in your account in order to open the trade. Generally speaking, the larger the value of your trade, the more margin required. It is important that you have sufficient funds in the account to place the trade. The margin calculator in the trading platform will automatically calculate your initial margin for you.

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Add stop and limit orders

Before you place your trade, it’s important to consider your risk management strategy.

A key risk management technique is to place an order such as a stop loss that will automatically close the trade if the market reaches a certain level.

A stop loss order is an instruction that allows the platform to close your open position once it reaches a specific level set by you. This will, as the name suggests, be at a price below the current market level and be triggered on losing trades to help minimise losses.

A limit order is an instruction to close out a trade at a price that is better than the current market level and is used to help lock in profit targets.

Standard stop losses and limit orders are free to place and can be placed in the dealing ticket when you first place your trade or once your trade is open.

Monitor your trade

Having placed your trade and any stops or limits, your profit and loss of your CFD trade will now fluctuate with each move in the market price.

You can track market prices, see your profit/loss update in real time and add new trades or close existing trades from your computer or by using our trading app on your smartphone or tablet.

Closing your trade

Once you are ready to close your trade, you need to do the opposite trade to the opening trade or select the ‘close position’ option within the positions window.

By closing the trade, your net open profit and loss will be realised and immediately reflected in your account cash balance.

This will be done for you if your stop loss or limit order has not been triggered.

CFD examples

Review the CFD trading examples to see how CFD trading works in practice.

Trade CFDs on over 5,000 markets

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Pricing and Charges

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Trading with us

CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 71% of retail investor accounts lose money when trading CFDs with this provider. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.

△ Based on CFD spreads and financing competitor comparison on 28/08/2020.

* Spread Betting and CFD Trading are exempt from UK stamp duty. Spread betting is also exempt from UK Capital Gains Tax. However, tax laws are subject to change and depend on individual circumstances. Please seek independent advice if necessary.

† 1 point spreads available on the UK 100, Germany 30, France 40 and Australia 200 during market hours on daily funded trades & daily future spread bets and CFDs (excluding futures).

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What is a contract for difference (CFD)?

CFD stands for Contract for Difference, and trading CFD’s is a certain form of speculation in the financial markets where you don’t need to buy or sell any underlying assets.

CFD’s appeared in early 1990s in London as a form of margin stock trading. The invention of CFD’s is generally attributed to Brian Keelan and Jon Wood, both from UBS Warburg, who developed these contracts while trading at Trafalgar House in early 90s.

Before CFD’s were introduced, only participants with large capital could trade market instruments at international exchanges, such as stock exchanges, as the cost of trading in such exchanges can reach hundreds of thousands of dollars. CFD’s opened access to market instruments trading to a wide range of people with different amount of capital.

Initially, CFD’s only consisted in the difference between the stock price. Today, such contracts are applicable to nearly all market instruments.

Currently, CFD transactions are allowed in such markets as indices, stocks, currencies, cryptocurrencies, and bonds, which you can trade without actually buying or selling stocks or currencies. Instead, you are trading a CFD, a derivative that offers a number of advantages compared to traditional trading.

Introduction to CFD Trading: How It Works

Let’s assume you want to buy 1,000 shares of a company stock. You can buy those through an exchange broker paying the total amount (1,000 x current market price per share) and the broker fee. Alternatively, you can buy a CFD for 1,000 shares through a CFD provider, also at the current market price.

This will give you the same exposure, but in order to open such a position you will only need to deposit a margin to cover the possible unsuccessful outcome, as well as a small fee. Selling shares with a CFD broker is easy as well: you just set your contract duration to short term instead of long term, at the bid price. This is why CFD’s are usually used by clients who want to hedge their existing investment portfolio.

What Are Margin and Leverage?

CFD is a leverage product, which means you need to deposit only a fraction of its total value in order to open your position. This is called margin requirement. While trading on margin allows you to boost your profit potential, it also magnifies your losses, which are based on the total CFD value.

In other words, you can deposit a small amount of money to manage a much larger position and magnify your possible earnings, but remember that your losses will magnify, too, so you will have to manage your risks appropriately.

Short and Long CFD Portfolios

Acquiring long or short CFD’s means betting on the asset price rising or falling. The difference between the long or short CFD is the potential loss or profit obtained from trading.

Taking a long position means buying a security expecting it to appreciate (rise). This is called long because it usually takes a longer period for the markets to go up than to fall. So, in essence, going long just means buying.

Taking a short position means selling a security expecting it to depreciate (fall). As a rule, the markers usually fall much faster and more abruptly than they rise, hence the name. Basically, going long means selling.

What Are the Costs in CFD Trading?

  • Spread: When you are trading CFD’s, you have to pay the spread, which is the difference between the ask price and the bid price. When you open a position, you pay the ask price, and when you exit the market, you pay the bid. The less is the difference between these two, the smaller price movement in your favor you will need to be in the money (i.e., earn profit). In Libertex, we always offer competitive spreads.
  • Swap: At the end of each trading day, any position that is carried overnight is subject to the so-called swap, which can be positive or negative depending on your trade direction and the respective interest rate.
  • Commission: When you trade CFD’s, you may also be required to pay fees or commissions separately.

For more detailed information on Libertex Trading Terms and Conditions, please click here.

Risks and Rewards

CFD’s offer a flexible alternative to traditional investing, and this is why they became popular with a variety of traders. The beginner investors can successfully trade CFD’s, but should research this topic first and gain profound knowledge in the risks and rewards involved before risking their money. With an appropriate knowledge base, the traders can use the advantages the CFD’s offer at max, while reducing the effect of the disadvantages.

CFD Advantages

Below, you will find a list of advantages of CFD trading that we have complied for your convenience. The investors using a medley of trading strategies will find out that some or all of these factors are compatible with their systems. The list will tell you why so many types of traders use CFD’s as a means of speculating in the financial markets.

  • Ability to profit both in rising and falling markets:
    An obvious advantage of CFD trading is that the traders are not limited to only one way of getting profit, such as opening positions in a bullish (rising) market. The ability to trade in both rising and falling markets adds a good deal of flexibility to your trading strategy and allows you to predict the underlying asset prices which may fluctuate both up and down.
  • Position Hedging:
    One of the risk management method used by the investors consists in hedging. For instance, if you have a long position in the stock market which is accumulating losses, you can open a position in the opposite direction through a short CFD. This could seem redundant for some, but this will help you to balance your loss, as if the stock position continues falling, the CFD trade will offer you some gains. Thus, hedging will allow you to limit your risks and avoid future losses.
  • Flexible contract sizes:
    Many CFD traders have an option to choose from a wide range of position sizes that could be compatible with different trading styles of account types. In general, beginner traders are recommended using small lot sizes in order to develop a successful trading strategy that would earn them profit in the long term. More experienced investors may opt for larger exposure in order not to be limited in their trading options.
  • Marginal trading:
    CFD’s offer marginal trading, which means a trader has to deposit only a fraction of the total position value. Let’s assume you have a short or long CFD position of $1,000. In case the broker margin requirement is 4%, you will need to deposit only $40 to open such a position. The good news here is that, if you are successful, you will get profits from the total size of your position, not just those 4%.

Risks CFD Trading Carries

As any other form of investment, CFD trading does carry risks. You can minimize most of them by appropriately researching this form of investing and sticking to your structured trading plan. However, you should remember there’s no way to eliminate the risks completely. The best you can do is reducing the possible negative effects, and to do so you need bear in mind the following.

Over-Leveraged Trading

By far, the biggest error newbies often commit is the decision to risk too much in a single trade. Such ‘over-leveraging’ occurs every time a beginner trading thinks that CFD’s are a way to get rich quickly. So once they get an opportunity to place leveraged positions with an increased profit potential, many of such traders abuse it and suffer substantial losses, which may lead as far as to getting completely broke.

This should not happen in fact, as the above error can be avoided easily. All you need is an appropriate risk management strategy, which will include using stop losses in order to limit your loss size and risking only a small amount of your total account balance. At all times, you should act reasonably in order to achieve a winning streak in the long term instead of trying to make a ‘home run’ with every single opportunity.

No Right to Vote

Many experienced CFD traders claim that one of the risks in CFD trading is not having the right to vote during the annual board meeting of the company, which is accessible to a regular stock trader. This is important, as after the position is opened, a trader can no longer determine the future policy of the underlying company and thus cannot influence the price direction.

Without influencing the company strategy, CFD traders have to admit that once the position is open, the markets will dictate the price, and the traders will only have to accept the results. This highlights the importance of the price prediction and the trading plan, some of the aspects you should pay maximum attention to.

Conclusion

CFD trading is ideal for the investors that want to get the best from their money.

However, it incurs significant risks and does not suit all investors. We strongly recommend you trading on a demo account first before putting your own money at risk.

CFD trading may be ideal for:

  • People looking for short term opportunities
    CFD’s are usually open for a few days or weeks, which is not considered a long term.
  • Those who want to take their own investment decisions
    Libertex only provides order execution services. We do not advise which positions to take and won’t trade on your behalf.
  • Those looking to diversify their portfolio
    Libertex offers trading in over 5,000 global markets, which includes stocks, commodities, currencies, and indices.
  • Active or passive traders alike
    You are free to trade as much or as little as you want to.

Our CFD services cover a wide range of asset classes. For more information, please refer to CFD Trading Costs . CFD is a flexible investment vehicle, as the contracts have no expiry date and you decide when you want to liquidate your position obtaining your profit or loss.

We hope you found this article helpful. We invite you to open a free demo account in order to try CFD trading with no risk of loss!

Please don’t hesitate to share your questions or ideas in the comments section.

Trading CFDs

Trading CFDs (Contracts for Difference) with an Australian Regulated Broker

What is CFD Trading
and How Does it Work?

CFDs or (Contract for Difference or Contracts for Difference) are a popular form of derivative instruments. Derivatives are financial instruments that allow you to trade an asset in the global markets without actually owning it. Common examples of derivative instruments are options, futures or swaps.

With CFDs you don’t have ownership of the actual assets. Rather, you exchange the price difference of the underlying asset, from the time that the contract was opened to when it is closed. This closing date or contract expiry date is not fixed, making CFDs different from other forms of derivatives, like futures. Your contract can be for the short term or continue for the long term.

One advantage of trading CFDs is that you can speculate on price movements in any direction, up or down. The gain or loss that you make will depend on whether your forecast pans out. With CFDs, you can trade a large variety of assets, including currencies, equities, indices, cryptocurrencies (including bitcoin) and commodities.

Sounds simple?
It is!

But, it is necessary to understand how this instrument works before trying your hand at it.

CFDs or Contracts for Difference are a popular form of derivative instruments. Derivatives are financial instruments that allow you to trade an asset without actually owning it. Common examples of derivative instruments are options, futures or swaps.

With CFDs you don’t have ownership of the actual assets. Rather, you exchange the price difference of the underlying asset, from the time that the contract was opened to when it is closed. This closing date or contract expiry date is not fixed, making CFDs different from other forms of derivatives, like futures. Your contract can be for the short term or continue for the long term.

One advantage of trading CFDs is that you can speculate on price movements in any direction, up or down. The gain or loss that you make will depend on whether your forecast pans out. With CFDs, you can trade a large variety of assets, including currencies, equities, indices, cryptocurrencies and commodities.

Sounds simple?
It is!

But, it is necessary to understand how this instrument works before putting your trying your hand it.

Video: CFDs Explained

How Does Trading CFDs Work?

To understand the whole process, you need to first know the concept of margin trading. Leveraged CFDs allow you to gain wide exposure to price movements, without needing to invest the total trade value. This means that leverage allows you to gain wider exposure to the market than what you could have done with the capital in your trading account.

How Do CFDs Work?

To understand the whole process, you need to first know the concept of margin trading. Leveraged CFDs allow you to gain wide exposure to price movements, without needing to invest the total trade value. This means that leverage allows you to gain wider exposure to the market than what you could have done with the capital in your trading account.

Trade CFDs – What is CFD Margin?

When you start trading CFDs, you will need to open a “margin account,” preferably with a regulated broker. The broker will allow you to trade larger positions, by offering leverage. This means that you get the opportunity to magnify your earnings, with a small capital investment from your end. However, remember that leverage can also magnify losses. So, choose your leverage wisely.

To maintain your margin account, a fixed minimum amount of capital has to be present in the account at all times, to serve as a cushion against potential losses. This is known as the “initial margin” or “deposit margin.” It is the difference between the funds you borrow from your broker and the full trade value of your position.

In case you incur losses, and the capital in your account is depleted below the required level, the broker will issue a “margin call.” This means that you will need to deposit the required amount in your account, known as the “maintenance margin.”

This margin percentage will depend on the country from where your trade. Different regulatory bodies have different limits for leverage. These limits have been put in place to protect traders against significant losses during time of heightened volatility.

Going “Long” or “Short”
in CFD Trading

When you trade CFDs, you can speculate on whether the market prices will move up or down. If you believe that the prices will rise in the future, you buy the underlying asset or “go long.” But, if you think that prices will decline in future, you sell the asset, or “go short.” You still get to exchange the difference between prices at open and close, but you get a chance to benefit from declining prices as well

An Example of Leveraged CFD Trading

Suppose you want to trade CFDs, where the underlying asset is the US30, known as the ‘’Dow Jones Industrial Average Index. ” Let us suppose that the US30 is trading at:

Bid/Ask Spread

Now, “bid” is the selling price. This is what you sell the asset at. The higher of the two is the “ask price” or buy price; the rate at which you buy the asset. The difference between these two prices is the “spread.” This is your cost of trading. Depending on how liquid your asset is and your choice of broker, the spread can be tight or wide. For instance, an ECN broker can source quotes from a large pool of liquidity providers to offer you the tightest bid/ask spreads.

Bid/Ask Spread

Now, “bid” is the selling price. This is what you sell the asset at. The higher of the two is the “ask price” or buy price; the rate at which you buy the asset. The difference between these two prices is the “spread.” This is your cost of trading. Depending on how liquid your asset is and your choice of broker, the spread can be tight or wide. For instance, an ECN broker can source quotes from a large pool of liquidity providers to offer you the tightest bid/ask spreads.

Now, getting back to the trade, you decide to buy 5 contracts of US30 because you think that the US30 price will rise in the future. Your margin rate is 1% . This means that you need to deposit 1% of the total position value into your margin account.

In the next hour, if the price moves to 22100.00/22112.00, you have a winning trade. You could close your position by selling at the current (bid) price of US30 which is 22100.00

In this case, the price moved in your favor. But, had the price declined instead, moving against your prediction, you could have made a loss. This continuous evaluation of price movements and resultant profit/loss happens daily. Accordingly, it leads to a net return (positive/negative) on your initial margin. In the loss scenario where your free equity, (account balance+ Profit/Loss) falls below the margin requirements (1105), the broker will issue a margin call. If you fail to deposit the money, and the market moves further against you, when your free equity reaches the 50% of your initial margin the contract will be closed at the current market price, known as the “stop out.”

Notice how a small difference in price can offer opportunities to trade? This small difference is known as “pip” or “percentage in point.” For Indices, 1 pip is equal to a price increment of 1.0 which is also called an Index point. In the forex market, like in the above example, it is used to denote the smallest price increment in the price of a currency. For assets like the AUD/USD, which include the US Dollar, a pip is represented up to the 4th decimal place. But, in case of pairs that include the Japanese Yen, like the AUD/JPY, the quote is usually up to 3 decimal places.

This continuous evaluation of price movements and resultant profit/loss happens daily. Accordingly, it leads to a net return (positive/negative) on your initial margin. In case your initial margin is lower, the broker will issue a margin call. If you fail to deposit the money, the contract will be closed at the current market price. This process is known as “marking to market.”

How to Hedge Using CFDs?

Now, “bid” is the selling price. This is what you sell the asset at. The higher of the two is the “ask price” or buy price; the rate at which you buy the asset. The difference between these two prices is the “spread.” This is your cost of trading. Depending on how liquid your asset is and your choice of broker, the spread can be tight or wide. For instance, an ECN broker can source quotes from a large pool of liquidity providers to offer you the tightest bid/ask spreads.

A significant advantage of CFD trading is the opportunities to hedge your portfolio against short-term market volatility, within an existing position. Hedging is a strategy you can use when you want to invest to protect against downside risks. You can also limit your gains to do this.

So, let’s say you have an equity portfolio worth AUD 150,000, consisting of prominent shares on the ASX 200 index. These are split up in 10 tranches of AUD 15,000 each. You could own AUD 15,000 worth of Adelaide Brighton shares and AUD 15,000 worth of ANZ Banking Group Ltd.

Now, if you believe that both these companies might suffer a short-term dip in share price, due to a bad earnings report, you could offset some of the potential loss by going short on them through a CFD.

Instead of selling these shares in the open market, you assume two CFD short positions in Adelaide Brighton and ANZ Banking Group Ltd. About 10% of the market exposure, which is AUD 3,000, could be required to set up this hedge.

But, why choose a CFD short rather than simply selling the shares and buying them again later, after the price drops? The reason to choose the CFD route could be:

  • You will attract capital gains when you sell your shares, which is taxable. This will be unnecessary, unless you want to get rid of these assets once and for all. In CFDs, you won’t need to pay stamp duty and trading costs will be limited to margin and spread.

  • If the market does go downwards, the losses in your equity portfolio will be offset by your short CFD positions.

Hold Period

Now, after the market closes each day, any CFD position open in your account could incur holding costs. This depends on the applicable holding rate, as well as the direction of your position; based on which the cost can be negative or positive. The holding cost is one of the costs of trading CFDs.

Hold Period

Now, after the market closes each day, any CFD position open in your account could incur holding costs. This depends on the applicable holding rate, as well as the direction of your position; based on which the cost can be negative or positive. The holding cost is one of the costs of trading CFDs.

Start Trading CFDs with an Australian Regulated Broker

How Do You Start Trading CFDs?

Take a look at these 6 steps to start trading CFDs:

Step 1 | Build Your Knowledge

Considering that you are reading this article, you are already on Step 1. Learn all you can about CFDs and how to trade them. Know how they differ from other forms of trading.

Step 2 | Open a Margin Account with a CFD Broker

Register and open a CFD account with a regulated CFD broker, so that your funds are protected and you gain access to robust risk management and trading tools. You will need to deposit your initial margin in your trading account before you can start trading. Check margin requirements and choose the leverage ratio based on your risk profile. Leverage can erode your entire capital, if the market moves in the wrong direction. Start by practising what you learn on a demo account.

When you choose to trade with a regulated broker, you get:

  • Client fund segregation
  • ECN pricing
  • Robust trading platforms
  • Deep liquidity
  • Ultra-low spreads
  • Maximum leverage up to 500:1
  • Wide range of financial instruments
  • Educational resources
  • News and economic calendar
  • Secure trading and fund transfer

Step 3 | Create a Trading Strategy

First choose the asset you want to trade. CFDs can offer you exposure to numerous asset classes, all from a single trading platform. It all depends on your trading capital, time commitment, risk-reward ratio, market knowledge, goals and preferred strategies. Having a proper trading plan and sticking to it is essential for maintaining discipline and implementing good real-time risk management strategies.

Step 3 | Create a Trading Strategy

First choose the asset you want to trade. CFDs can offer you exposure to numerous asset classes, all from a single trading platform. It all depends on your trading capital, time commitment, risk-reward ratio, market knowledge, goals and preferred strategies. Having a proper trading plan and sticking to it is essential for maintaining discipline and implementing good risk management strategies.

Step 4 | Gain Familiarity with Technical and Fundamental Analysis

When you want to find trading opportunities, there are two approaches to analysing the market, fundamental analysis and technical analysis. In the former, by keeping track of geo-political events, economic data releases and breaking news events, you can stay tuned to events that might move the global financial markets. Learn how these events can lead to price fluctuations and volatile markets.

Next is technical analysis. Through the use of technical indicators, you can make informed decisions about potential price trends and patterns in the future. On robust CFD trading platforms like MT4 and MT5, there are pre-installed indicators and charting tools that can help you analyse the market comprehensively.

Step 5 | Create a Trading Strategy

Choose a platform that gives you flexibility and stability in trading. State-of-the-art technologies like MT4 and MT5 provide a wide range of tools to track price fluctuations, market news, manage risk and get alerts anywhere and anytime. Test your system on a demo account to see if it suits your requirements and trading style.

Step 5 | Create a Trading Strategy

Choose a platform that gives you flexibility and stability in trading. State-of-the-art technologies like MT4 and MT5 provide a wide range of tools to track price fluctuations, market news, manage risk and get alerts anywhere and anytime. Test your system on a demo account to see if it suits your requirements and trading style.

Step 6 | Always Use Stop Loss

Risk management is essential for every trade, no matter the market conditions or the position size. To restrict potential losses, here are some tools you can use:

Stop Loss Order: A smart placement of a stop loss order will allow the system to automatically close your position when the market reaches a certain price level. This can minimise losses when the market moves in an unfavourable direction.

Take Profit: This order closes out your position once you have gained a specific level of profit. This protects your positions from unnecessary market risk.

Trailing Stops: This moves your stop-loss further, if the market goes in your favour, but as soon as the market reverses, it closes the position. This order prevents your positions from getting closed too early.

For more in-depth fundamental and technical analysis plus trading education,
please visit our Traders Hub blog.

Advantages of CFD Trading

So, provided that you are in the hands of a regulated broker, you invest in education and have a robust trading system, CFD trading can actually provide you a lot of opportunities for long term success.

Start Trading CFDs with an Australian Regulated Broker

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DISCLAIMER: This material on this website is intended for illustrative purposes and general information only. It does not constitute financial advice nor does it take into account your investment objectives, financial situation or particular needs. Commission, interest, platform fees, dividends, variation margin and other fees and charges may apply to financial products or services available from FP Markets. The information in this website has been prepared without taking into account your personal objectives, financial situation or needs. You should consider the information in light of your objectives, financial situation and needs before making any decision about whether to acquire or dispose of any financial product. Contracts for Difference (CFDs) are derivatives and can be risky; losses can exceed your initial payment and you must be able to meet all margin calls as soon as they are made. When trading CFDs you do not own or have any rights to the CFDs underlying assets.

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Contract for Difference (CFD)

What is a Contract for Difference (CFD)?

A Contract for Difference (CFD) refers to a contract that enables two parties to enter into an agreement to trade on financial instruments Marketable Securities Marketable securities are unrestricted short-term financial instruments that are issued either for equity securities or for debt securities of a publicly listed company. The issuing company creates these instruments for the express purpose of raising funds to further finance business activities and expansion. based on the price difference between the entry prices and closing prices. If the closing trade price is higher than the opening price, then the seller will pay the buyer the difference, and that will be the buyer’s profit. The opposite is also true. That is, if the current asset price is lower at the exit price than the value at the contract’s opening, then the seller, rather than the buyer, will benefit from the difference.

A Contract for Difference gives traders an opportunity to leverage their trading by only having to put up a small margin deposit to hold a trading position. It also gives them substantial flexibility and opportunity. For instance, there are no restrictions regarding the timing of the entry or exit and no restrictions of time over the period of exchange. There is also no restriction on entering a trade buying or selling short.

Understanding the Building Blocks of CFD

Unlike stocks, bonds, and other financial instruments where traders must physically own of the securities, CFD’s traders don’t hold any tangible asset. Instead, they trade on margin with units that are attached to a given security’s price depending on the market value of the security in question. A CFD is effectively the right to speculate on changes in price of a security without having to actually purchase the security. The name of this type of investment basically explains what it is – a contract designed to profit from the difference in the price of a security between the opening and closing of the contract.

Example: Understanding CFD Loses and Gains

Imagine Joe is a trader. In recent days, he’s been speculating on oil prices. Since oil prices are highly volatile, Joe understands the risks involved in opening a position in a such an asset. However, he thinks he stands a chance to make some profits from the trade. With the help of his unique recipe, he’s noticed a given favorable trend in oil prices.

Due to his keen analysis, he’s confident that the prices will rise by a margin of 12% per barrel in the next year. Let’s say the current price is $50 per barrel. According to Joe’s speculation, the closing price at year end will be $56. So, he approaches his CFD brokers who buy him 25,000 units. Therefore, Joe expects in a year’s time, his investment will grow to (25,000 units * $56) $1.4 million, making him (25,000 units * $56 – 25,000 * $50 or $1.4 million – $1,2 million) $200,000.

Unfortunately, the market hits a dip, and the prices start dropping. Before he suffers more losses; Joe decides to exit at $48 per barrel. In this case, Joe will only lose (25,000 units * $50 – 25,000 units * $48 or $1.25 million – $1,2 million) $50,000.

Interpretation

A trader stands a chance to either lose or gain depending on market trends. Also, to buy and sell CFD units, the trader doesn’t deal with limitations of fixed time for entry and exits.

Common Terms of Contract for Difference

Trading Terms: Going Long vs Going Short

Going Long – When traders open a contract for difference position in anticipation of a price increase, they hope the underlying asset price will rise. For example, in the case of Joe, he expected that oil prices would increase. So we can say he traded on the long side.

Going Short – Using a contract for difference, traders can open a sell position based on anticipating a price decrease in the underlying asset. Trading from the sell side is known as going short.

Relationship between Margin and Leverage

In CFDs contracts, traders don’t need to deposit the full value of a security to open a position. Instead, they can just deposit a portion of the total amount. The deposit is known as “margin”. This makes CFDs a leveraged investment product. Leveraged investments amplify the effects (gains or losses) of price changes in the underlying security for investors.

Spread – The spread is the difference between the bid and ask prices for a security. When buying, traders must pay the slightly higher ask price, and when selling they must accept the slightly lower bid price. The spread, therefore, represents a transaction cost to the trader, since the difference between the bid and ask prices must be subtracted from the overall profit or added to the overall loss.

Holding costs – These are charges over the open positions a trader may incur at the end of the trading day. They are positive or negative charges depending on the direction of the spread.

Commission charges – These are commissions that CFD brokers often charge for the trading of shares.

Market data fees – These are also broker-related costs. They are charges for exposure to CFD trading services.

Five Advantages of Trading Contracts for Difference

  1. Because CFDs are unique and often come with favorable margins, they attract many brokers across the world. So, trading in CFDs should not be a challenge to any trader who is looking forward to investing in CFDs.
  2. CFD trades on the fast-moving global financial markets. Therefore, traders get what is called direct market access (DMA), which gives them an opportunity to trade globally.
  3. Unlike other types of instruments that offer only a single opportunity, CFDs present a wide range of assets. They include global indices, sectors, currencies, stocks, and commodities.
  4. With CFDs, traders can benefit from either the rising or falling of asset prices.
  5. Traders in CFDs don’t need to invest the full amount. They only need to open buying or selling positions on margins.

Additional Resources

CFI is the official global provider of the Financial Modeling and Valuation Analyst (FMVA)™ FMVA® Certification Join 350,600+ students who work for companies like Amazon, J.P. Morgan, and Ferrari designation, a leading financial analyst certification program. To continue learning and advancing your career, these additional CFI resources will be helpful:

  • Trading Mechanisms Trading Mechanisms Trading mechanisms refer to the different methods by which assets are traded. The two main types of trading mechanisms are quote driven and order driven trading mechanisms
  • Long and Short Positions Long and Short Positions In investing, long and short positions represent directional bets by investors that a security will either go up (when long) or down (when short). In the trading of assets, an investor can take two types of positions: long and short. An investor can either buy an asset (going long), or sell it (going short).
  • Strike Price Strike Price The strike price is the price at which the holder of the option can exercise the option to buy or sell an underlying security, depending on whether they hold a call option or put option. An option is a contract with the right to exercise the contract at a specific price, which is known as the strike price.
  • Sale and Purchase Agreement Sale and Purchase Agreement The Sale and Purchase Agreement (SPA) represents the outcome of key commercial and pricing negotiations. In essence, it sets out the agreed elements of the deal, includes a number of important protections to all the parties involved and provides the legal framework to complete the sale of a property.
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