When assessing the latest Forex news stories and strategies, one of the terms you are most likely to come across is “CFD”. Whilst familiar to those within the industry, or with a decent level of trading experience under their belts, this term may initially be confusing to the uninitiated. It is nevertheless an important phrase to understand, whether you be considering dipping your toes into the Forex trading waters or assessing the best trading forex sites.
Here we take a closer look at the world of CFDs, assessing exactly what they are, and the pros and cons associated with selecting them as a trading option.
What is a CFD?
First things first CFD stands for Contract For Difference. CFDs fall into the derivative category of finance – derivatives being financial contracts that “derive” their value from the performance of the underlying asset to which they are related.
Rather than buying and selling a specific asset, derivatives effectively allow traders to make bets on how that asset will perform – without ever needing to own the asset itself.
Derivatives style products come in a variety of forms and are available across a range of asset types, including:
- Bonds
- Stocks
- Commodities
- Interest Rates
- Cryptocurrencies
- Currencies
When looking to trade with a CFD broker, the trader will be presented with both a buy price and a selling price. For example, a CFD for gold may be available to buy for $1190 or sell for $1185. That $5 difference between the prices is known as the spread and represents the profit taken by the broker.
Traders who expect the value of gold to increase would place a BUY order, and later look to sell back at a higher price, whilst those who anticipate the value to fall would sell at $1190, and then buy back at a lower price should the value drop as predicted.
In both cases, CFD trading follows the basic premise of trading. In the buyer’s case, buy low, sell high, and in the seller’s case, sell high, buy low.
Leveraged Trading
One of the main advantages of trading via a CFD platform is that it enables a trader to significantly leverage their funds. In essence, traders are able to gain full exposure to the market at a fraction of the cost.
For example, consider a trader wishing to open a CFD trade on 100 Tesla shares at a price of $300 per share. With a standard trade, this would require total capital of $30,000 (100 x 300 = $30,000). However, many CFD platforms will allow traders to trade on a 20%, 10%, or even a 5% basis.
Using the 5% figure, the trader would be able to gain exposure to the full $30,000 of the trade, for a cost of only $1,500 (5% of $30,000 = $1,500). However, when calculating the trader’s profit or loss, it would be the change in the full $30,000 value of the trade which is used.
This is a huge benefit to the trader should they call the price change correctly. However, remember that it also works in the other direction, which may result in significant losses should the trade go against you – a relatively small market shift may see the full value of your investment wiped out.
Benefits of CFD Trading
- One of the most effective ways in which to trade in the price movements of commodities, including in the Forex market.
- A means to trade without the necessity of buying and selling the stock, security, commodity, or currency itself.
- Leveraging offers the potential to maximize the profitability of a relatively low level of capital.
- Trade in and out of positions quickly and easily.
Downsides of CFD Trading
- High leveraging levels can intensify losses.
- Volatile markets often come with a very high spread which is a disadvantage to the trader.
- Extreme market swings may result in the broker making a margin call, requiring the trader to make an additional deposit with their broker.
A Useful Tool When Used Sensibly
All told CFDs are a useful tool to have in your trading armory, and well worth seeking out at the top online brokers. As with all methods of trading, the best advice is to initially err on the side of caution and budget sensibly. Sticking to the less volatile markets with a lower spread is also advisable for those new to the CFD arena.
