CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage 70.02% of retail investor accounts lose money when trading CFDs with INFINOX. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.
CFDs are an accessible and popular tool for forex and financial traders. But if you’re still getting to grips with the details, you’ll be wondering what is the definition of a CFD?
A ‘contract for difference’ (CFD) is an agreement, where the investor buys a contract anticipating a change in value on a particular financial product. By purchasing a CFD you’re not buying the underlying asset. This means you can use leverage to increase the size of the contract using a smaller deposit (margin).
Unlike traditional trading, CFD traders do not have to buy a particular asset and sell it at a higher price in the future in order to make a profit.
Instead, the trader performs makes a judgement about whether the value of an asset will rise or fall. If the trader correctly predicts the outcome, the seller pays the difference between the price of the asset at the start and end of the deal. On the other hand, if the trader misses the forecast and the asset moves in the opposite direction, the trader is expected to pay the difference.
For example, if the value of a share is $30 at the opening of a contract and $31 at the close of the contract, then the difference would be 1. If the investor acquired 1,000 CFDs and predicted that the share value would rise, the profit made would be 1,000 x 1 = $1,000. That is, the trader profits from a stock increase without having to buy the stock.
Contrary to stock and futures transactions, where the broker is simply an intermediary, CFD transactions are always negotiated with the broker’s counter-party, which allows greater agility and quality in the negotiations. This type of operation is called over-the-counter (OTC).
You can trade different assets with CFDs, such as:
One of the most common uses of CFDs is for traders to speculate on forex (currencies). As such, we’ll use forex to provide an exemplify the mechanism of CFD trading.
CFDs make forex trading a much more accessible market for many. For example, if a trader wants to invest on the movement of the US Dollar against the Euro, rather than spending thousands on buying the currency, a trader can take out a CFD instead.
A contract for difference (CFD) allows traders to use a fraction of the total value of a “lot” to invest. A standard lot size in forex trading is 100,000 currency units (Dollars, Euros, GBP, etc), although there are also mini-lots (10,000) and micro-lots (1,000).
So, how do you use a fraction of the total value to access a “lot”?
When you open your trading account you will deposit money, which becomes your balance or your equity. If you then want to open a CFD you would use the leverage available to create the margin for your trade.
For example, if the leverage available is 10:1 you could put in $1,000 to access an investment of $10,000. The $1,000 is your margin (deposit) and the available leverage of 10:1 means you stand to make profits or losses based on the full value of the $10,000. So if your trade goes up 2% to $10,200 and you close your position, you would make a profit of $200. Your initial margin was $1,000, so you have made a profit of $200 on your $1,000 margin, which is the equivalent of a 20% return. However if the trade went down 2%, your loss of $200 means you would have made a 20% loss.
This extremely simplified example also doesn’t take into account any fees associated with the transaction. Some brokers might charge a commission or a flat fee on any trades as well as the spread.
Take a look at our Spreads and Margins explanation to find out more.
CFD trading offers the possibility of a higher profit with a lower investment. On the other hand, both losses and profits can be increased. Therefore this instrument must be carefully operated, and like any other investment, risk control is critical to avoid unwanted damage.
It’s recommended that CFD traders study hard and have a well-defined trading strategy that, coupled with good emotional readiness, can generate above-average returns.