If you have heard of CFDs as a great revolution in online trading but have not understood exactly what CFD meaning is and how it works, this article for you.
June 03, 2021 | AtoZ Markets – Have you recently become interested in online trading and have been advised to invest in CFDs, but you have no idea what they are? Or are you simply looking for new ways to invest in CFDs today?
You are in the right place: in this article, we offer you a complete guide to trading on Contracts for Difference, explaining CFD meaning, how it works, and helping you to understand whether investing with CFDs is right for you or not.
Contract for Difference is a very popular tool in trading and an increasing number of investors are making use of it daily. By choosing CFDs, you invest in a financial instrument whose price depends on the underlying, or another instrument – such as shares, forex exchange rates, indices, commodities – avoiding bureaucracy and opening positions faster.
But what are CFDs exactly? How do they work?
Let’s be clear.
Thanks to the offer of reliable Forex brokers, it is possible to learn how to invest in CFDs through Demo accounts, on which to train to generate profit with virtual money.
Only when you feel ready will you be able to invest in CFDs with real money and earn thanks to the Contract for Difference features. Understanding the CFD meaning and how they work is a fundamental step for those who want to deepen their knowledge of online trading and profit from it. However, it should be known that CFDs may not be suitable for all investors, and for this reason, it is important to know them well: here is a clear and complete guide.
The term CFD means Contract for Difference and are the derivatives that are used to exchange other financial products, without actually owning them. CFD trading was born in the 90s and has achieved great popularity since then.
Before now, buying shares could be difficult due to their high price, or possible unavailability.
This is where CFDs come in: thanks to them, every trader can enter into purchase or sale contracts with their own broker or intermediary, at the time and in the ways they like best. It should be noted that with CFDs, the trader does not really own the chosen financial asset, but has a contract with the broker that exactly replicates the quotation of the reference product.
In short, these instruments are called Contract for Difference because the traded instrument (share, index, etc.) will be traded according to real market conditions, and the gain (or loss) will exactly reflect the difference between the purchase price and the sale of the financial product, exactly as it happens on the stock exchange.
That said, let’s find out the convenience of trading CFDs.
Is CFD Trading Scam?
No, CFD trading is not a scam. There are dozens of legal and safe brokers that allow you to invest through these tools. However, not all of them are legitimate. Not all of them are able to offer you a safe and controlled trading environment, also thanks to the presence of licenses.
There are also many scams that we report every day to warn our readers against operators who really have no qualms and who only exist to scam their interlocutors.
But this does not mean that you will not be able to find, also thanks to our advice, brokers that allow you to invest in CFD trading with top security.
How do CFDs work?
To fully understand how CFDs work, we can use a practical example. Let’s say that a trader carries out a technical analysis according to which he predicts an appreciation of Google shares from $750 to $800 each: he will need to shell out well $750 to buy a single share and make a profit, in case his analysis turns out to be correct, of $50 except for commissions. This is as long as someone is willing to sell him a single share.
Here is another concrete example based on Google shares:
- Bullish CFD (Long): if you think the price will rise, with a click on “Buy” you will earn from its rise.
- Bearish CFD (Short): if you think the price will drop, click on “Sell” and for each Pips of fall you will make a profit.
The fluctuations in raw material prices, such as oil, gold, coffee, gas, and many others, have a strong impact on the world economy. Investors take advantage of these changes to trade commodities. The same goes for cryptocurrencies, the famous cryptographic virtual currencies that can be traded on blockchain platforms. Investing in cryptocurrencies through CFDs, thanks to financial leverage, allows you to obtain greater profits than the traditional system. However, being a market characterized by high volatility, it is suitable for more experienced investors who can afford any losses.
Novice traders should avoid cryptocurrency CFDs because if the market moves against their interests, they can incur substantial losses. Thanks to CFDs, however, the trader can at any time decide for himself the amount to invest and has the possibility of limiting himself to much lower amounts, at the same time amplifying any gains thanks to the use of financial leverage.
Advantages of CFD trading
Below we will list the main advantages in trading CFDs:
- Zero commissions: the only charge to be considered is in fact the spread, i.e. the difference between the purchase price and the sale price
- No expiration: the Trader can keep the position open as long as he wants
- Leverage effect: possibility of opening much more expensive positions than the capital of the deposit
Bear in mind that CFDs are high risk financial instruments and are therefore suitable for investors who have extensive experience in trading on volatile markets.
Before investing in CFDs it is recommended to refine your knowledge and gain experience using the demo account with virtual money. Only then will it be possible to switch to a live account.
CFD trading with leverage and margin
When trading CFDs, it is possible to expose yourself to the market with a higher amount than the deposit. This is feasible for the simple fact that CFDs are leveraged products.
What is leverage? To understand this, let’s try to be very concrete and give an understandable example.
Let’s stop for a moment to think of leverage as a factor capable of increasing a specific amount – the deposit – to allow the trader to operate with a higher sum than that initially put in place.
Let’s say that a person registered with a particular broker deposits $100. In case of 1:10 leverage, he has the possibility to trade CFDs as if, in reality, he had put 1000 in the field.
To allow the trader to operate through leverage, the broker grants the loan of a certain amount of money. You have to be very careful when using leverage.
For what reason? For the simple fact that all the results, both the winning ones and the unhappy ones, are calculated on the highest figure. Leverage, in a nutshell, multiplies losses, and is, therefore, a double-edged sword.
On the one hand, it offers the possibility of generating strong profits in a short time, and on the other, it can turn into a trap capable of eroding all the invested capital.
Be aware that the higher the leverage, the greater the risk.
What about margin? Explaining this aspect is very important. Let’s remember first of all that, in CFD trading, we talk about two types of margin. Here are which ones:
This definition indicates the amount that will actually be put in place by the user for the single trade.
How is it calculated? Starting from this operation: opening price of the single position x size of the transaction x percentage of initial margin.
Let’s take a more concrete example to better understand. Let’s imagine the case of a trader who decides to buy 20 CFDs on Apple shares for $100 each. If the margin is 10%, the position value is $200.
With these expressions, we mean the margin that is asked by the broker to hold the position open. It is repaid when the trader decides to close the position.
To calculate the amount it is necessary to perform the following operation: price of the asset at the time of opening the position x size of the transaction x percentage of the maintenance margin.
CFD Meaning – Conclusion
In this guide, we have offered a comprehensive overview of trading with CFD. So we believe you must have understood the CFD meaning. CFDs are increasingly gaining popularity in recent years, thanks to the various trading platforms that promote product derived.
However, we would like to conclude by saying CFD trading involves a higher level of risk. Hence, we highly recommend that you gain familiarity and experience before starting to delve into this world. In case you are unfamiliar or experienced, trading CFDs may not be appropriate for you.
That said, in order to invest in CFDs, you will always, and continuously, keep yourself informed about what is happening in the financial markets. It is also of fundamental importance to participate in trading courses and always check that the broker chosen to operate on the stock exchange is serious and not an online trading scam.
FAQ: Common questions and answers on CFDs
- How much does it cost to trade CFDs?
CFD trading has variable costs based on the volume traded (variable spreads) plus any overnight costs whose level varies according to the broker.
- Is it safe to trade CFDs?
Yes, as long as you only use the best platforms that we recommend.
- What are the benefits of CFD trading?
CFD trading allows you to make profits both when the value of a financial security falls, and when it rises. Also, you can apply leverage to multiply your profits.
- Is CFD trading suitable for everyone?
With a little effort and study, even beginners can learn CFD trading.
- Where to trade CFDs?
The main markets on which it is possible to invest in CFDs are forex, commodities, stocks, ETFs, indices, and cryptocurrencies.
- What are the best CFD brokers?
AtoZ Markets has compiled a complete list with the online CFD brokers.
- How to learn CFD trading?
It takes a lot of practice to train properly. We, therefore, recommend opening a free demo trading account on the best brokers recommended on our site.