What are CFDs?

A Contract for Difference (CFD) is a financial derivative that allows traders to speculate on the price movements of various financial instruments, such as stocks, indices, commodities, and currencies, without actually holding the underlying asset.

CFDs are contracts listed on a broker's platform where the parties agree to exchange the difference in the value of the underlying asset from the time the contract is opened to when it is closed.

How Does the CFD Trading Work?

In CFD trading, you don't own the underlying asset physically. So when you are buying and selling, you do it through the number of units of these assets. Here are the steps to start trading CFDs:

• Opening a Position
• Contract Agreement
• Speculating on Price Movements
• Profit and Loss Calculation
• Leverage and Margin
• Closing a Position
• Settlement
• Fees and Charges

In order to start CFD trading, you must work with a broker that offers CFD trading first. Assuming you have your broker, let's take a look at these steps in a bit more detail.

Opening a Position: In the beginning, you have to select an asset such as stocks, indices, commodities, and currencies. Then decide on going long or short with your selected assets.

Contract Agreement: When opening a position in CFD trading, you enter into a contract with the broker. This contract puts out the terms of trade including the assets, size of the position, and any associated costs such as spread and financing charges.

Speculating on Price Movements: This is the part you need to decide if you want to go long or short with your selected assets.

Profit and Loss Calculation: Profits and losses in CFD trading are determined by the difference between the opening price and the closing price of the CFD position. If the price moves in the way you're expecting, you make a profit, if not you can face loss.

Leverage and Margin: CFD trading often involves leverage, allowing you to control larger positions with a smaller amount of capital. You're also required to deposit a fraction of the total position size, known as margin.

Closing a Position: You can close your CFD position at any time during market hours. You can do it by entering a trade in the opposite direction of your initial position.

Settlement: At the end of the trading day, CFD positions are settled. Your profits or losses will be credited according to the differences between the opening and closing prices.

Fees and Charges: Various fees and charges are found in CFD trading such as spreads, overnight financing costs, and commissions.

Advantages of CFD Trading

Since traders do not own the underlying asset, they can profit from both rising (going long) and falling (going short) markets, allowing for opportunities in various market conditions. Trading CFDs is popular because of several advantages. These advantages are factors such as:

• Leverage
• Access to multiple markets
• Ability to go long or short
• Flexibility
• Cost-efficiency
• Speculative trading

Let's go ahead and explain these factors in more detail, starting with leverage.

Leverage

Leverage is a key aspect of CFD trading, and it's important to understand its implications before engaging in such transactions. CFDs allow traders to control larger positions with a smaller amount of capital, amplifying potential returns.

In CFD trading, leverage is usually given as a ratio, such as 10:1 or 50:1. This means that for every unit of capital placed, the trader can manage a market position that is ten or fifty times greater.

Leverage is advantageous in terms of amplified profits and capital efficiency. However, it has its own risks such as magnified losses and margin calls. It's possible to approach them with risk management strategies. You can set stop-loss orders to help limit potential losses by closing out positions automatically. It may be a helpful strategy if the market moves against you beyond a certain point. Another thing you can do is assess your risk tolerance and only use leverage that aligns with your risk management strategy.

Access to Multiple Markets

Accessing multiple markets is a significant advantage in CFDs. It's possible to work with a broker that trades CFDs and trade on various financial markets including stocks, indices, commodities, and currencies. So, you wouldn't have to open separate accounts with different brokers. This can save you a lot of time and effort.

With access to diverse markets, traders can capitalize on opportunities regardless of whether the market is bullish or bearish. They can go long (buy) on assets expected to rise in value or short (sell) on assets expected to decline.

Another advantage of working with a CFD trading broker is having access to markets all over the world. You can take your trading strategies to an international level. Also diversifying across various markets can help divide risk and reduce the impact of negative events in a single market.

Ability to Go Long or Short with CFDs

One of the key features of Contracts For Differences trading is the ability to profit from both rising and falling markets by taking either long or short positions.

Long Positions: When traders go long in a CFD trade, they are essentially buying an asset with the expectation that its price will increase over time. If the price of the underlying asset rises, the trader can sell the CFD at a higher price, thus profiting from the price difference.

Short Positions: In contrast, going short in a CFD trade involves selling an asset that the trader does not own, with the intention of buying it back at a lower price in the future. If the price of the underlying asset decreases after selling short, the trader can buy back the CFD at a lower price, realizing a profit from the price difference.

Whether you're going long or short in CFD trading, you can still profit in both bullish and bearish market conditions. This way you can still capitalize on market trends regardless of whether prices are rising or falling.

Although the ability to go long or short in CFDs can enhance profit potential, it also has its risks. As a trader, you have to consider market trends carefully and implement analysis and risk management strategies. You can minimize potential losses by taking short positions.

Flexibility

CFD trading is known for its flexibility. It provides traders with numerous options and strategies. This way traders can have multiple choices to approach their preferences and market conditions. Flexibility in CFD trading offers:

• Wide range of tradable assets
• Multiple markets and instruments
• Ability to trade on margin
• Variety of trading strategies
• Risk management tools

CFDs offer a diverse range of financial instruments such as stocks, indices, commodities, and cryptocurrencies. As a trader, you can choose from a wide variety of assets based on your interests and market opportunities.

CFD brokers including zForex, typically offer access to global financial markets, allowing traders to participate in markets around the world from a single trading platform.

CFD trading allows traders to leverage their positions by trading on margin. This means that traders can control a larger position size with a smaller initial investment. This can help increase the profit.

It's possible to trade CFD assets with a large variety of trading strategies. This way you can perform your strategies in different market conditions and timeframes while maximizing your profit potential. CFDs can be traded in trading strategies such as day trading, swing trading, and position trading.

One other good thing about CFD trading is that many CFD brokers offer risk management tools such as stop-loss orders and limit orders. This can help you minimize the risk and protect your capital as well.

Cost Efficiency in CFD Trading

Cost efficiency is a significant advantage of CFD trading, offering lower transaction costs compared to traditional investing methods.

The cost-efficiency in CFDs starts with having no ownership of underlying assets. With CFD trading, you can speculate on price movements without taking ownership of the assets. This eliminates costs associated with asset ownership, such as stamp duty taxes, registration fees, and custody fees.

In some jurisdictions, profits from CFD trading may be taxed differently than dividends or capital gains from holding underlying assets. Even in some countries, CFD trading is not subject to taxation at all. 

All sounds good but aren't there any costs of trading besides taxation? Yes, however, lower costs compared to other trading products. When trading CFDs, you will have to pay spread for your transactions. 

Speculative Trading

Speculative trading is a common strategy performed by CFD traders. It focuses on short-term price movements to profit from market fluctuations.

Speculative traders often rely on technical analysis techniques to identify potential entry and exit points based on historical price data, chart patterns, and technical indicators. By monitoring price charts and market patterns, they aim to foresee future price changes and make informed decisions. Day trading, swing trading, and high-frequency trading are among the popular speculative trading strategies.

When it comes to risks in speculative trading, what you can come across are volatility, leverage, and overnight financing costs. Effective risk management is essential in speculative trading. Stop-loss orders, diversifying positions, and limiting position sizes can help you reduce the risk.

CFDs in a Nutshell

CFDs are financial derivatives that allow traders to speculate on the price movements of various financial instruments, such as stocks, indices, commodities, and currencies. Traders do not own the underlying asset physically. The number of units is the one that matters in CFD trading.

We have mentioned how CFD trading works, and the various advantages of it when trading. Although CFD trading has many advantages, especially on the cost-effective side, it has its risks as well. However, you can minimize these risks by various risk management techniques as we have also mentioned in the article. 

FAQ About CFDs

Is CFD forex?

No a CFD is not a part of forex (foreign exchange). CFDs are derivative instruments that are traded for the price change of certain assets.

What is CFD trading?

CFD trading is a form of derivative trading where traders speculate on the price movements of various financial assets without owning the underlying assets.

How were CFDs invented?

CFDs were invented in the early 1990s by Brian Keelan and Jon Wood at the investment bank UBS Warburg. They were originally developed as a way for hedge funds and institutional investors to hedge against their exposure to stocks on the London Stock Exchange.

What are the risks in CFD trading?

Risks of CFD trading include market volatility, leverage amplifying both gains and losses, overnight financing costs, and counterparty risk with CFD providers.

What is the difference between CFD trading and traditional stock trading?

Unlike traditional stock trading, CFD trading allows investors to speculate on the price movements of various assets without owning the underlying assets.