What is CFD?

First, you should know that CFD stands for “Contract for Differences“. CFDs are a kind of contract that allow investors to speculate on financial markets without buying or selling any underlying assets. Investors can use CFDs in multiple markets such as forex, stocks, and commodities.

If traders think that the price of an underlying asset, such as gold, will go up, they can buy a CFD and benefit from that rise. They call this process “going long”. But if they think the price of an underlying asset will go down, they can sell their CFDs and profit from the fall. This is the opposite of the first process, and they call it “going short”. The different prices of entering and exiting positions make your profit. The more a market moves toward a predicted direction, the more your profit will be. However, sometimes the market moves against the expected direction and leads to a loss for traders.

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Traders usually use CFDs for short term or day trading, but it is possible to use them for more extended periods. CFD online trading platforms are very fast, and they enable traders to trade several times per day. Traders can trade in rising or falling markets, benefit from leverages, trade various asset classes from one account, and the cost of transactions is very low. The speed and flexibility of CFDs made lots of traders interested in short term trades.

A Brief History of CFD

This method was created in the early 1990s in London. Initially, traders looked at it as a simpler way of hedge funds for short selling in the London Stock Exchange. After a short time, it became publicly available for individuals. Many traders used it because it allowed them to benefit from leverage without paying taxes. After the development of the internet globally, CFD trading became accessible for many traders. Also, the creation of new mobile apps and websites has attracted the attention of many traders.

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How to make a profit with CFDs in rising or falling markets

If traders think the underlying asset’s price is going up, they can buy it and wait for the price to rise. Then they can sell it at a higher price and make a profit. They call this process “going long”.

However, if they expect a fall in the price of an asset, they can sell it at a high price and then repurchase it at a lower price. They call this strategy “going short”.

Trading CFD with leverage

Traders can use leverage to open a CFD position with lower initial funds. Then they can use the rest of their funds to open other positions. Therefore, this strategy is very cost-effective. However, as you know, trading with leverage is sometimes risky. Although it increases the profit in a successful trade, it also magnifies your loss in a bad investment. So, inexperienced traders must be very careful when they use leverages.

Example of CFD trading

Some people may find CFD trading confusing, but here we show you how it works. Imagine apple stocks are trading at 400$ (bid) / 404$ (ask). You buy 100 stock CFDs because you think the price of this stock will increase due to the announcement of a new iPhone. The value of this trade is 40,400$ (404×100). The margin requirement of buying this stock in the broker is 10%, so you need to deposit 4,040$ in your account (10% of the total amount).

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If your predictions are accurate and the price rises, for example, to 450$ (bid)/ 454$ (ask) within several hours, you can close your position at 450$. The price increased to 46$, and your gross profit will be 4600$ (46×100). Then, to calculate the net profit, you should reduce the fees and commissions from the gross profit.

Now imagine your predictions turn out to be wrong. Imagine the new iPhones have many problems, and the price falls to, for example, 330$ (bid)/ 334$ (ask) you will lose a lot of money. Here your gross loss will be 7400$ ((price difference 404-330) 74$ x (number of CFDs) 100). To calculate the net loss, you must also add fees and commissions to this amount (7400$).

Conclusion

CFD trading has many benefits such as low margin requirements, having access to various markets and low commissions. However, large leverages magnify your losses when the market does not move toward the predicted direction. The most effective way to understand CFDs ideally is using demo accounts. Demo accounts provide you with a safe environment where you can practice CFD trading with virtual money. DeltaFX broker offers a demo account to novice clients, and they can spend some time in these accounts to master the process.

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