What is CFD Trading?
Contracts for difference (CFD) are derivatives, as the price of a CFD is derived from the value of an underlying asset. When you trade a contract for difference, or CFD, you’re not actually trading a physical asset. Instead you’re agreeing to exchange the difference in value of an asset between the point at which the contract is opened and when it is closed.
For example, you might open a CFD based on the price of gold, with the expectation the metal will rise in value. If the price of gold does indeed go up and you then close the contract, you will have made a profit. If it drops, you’ll have made a loss.
Of course, the more the market moves in your favour, the more money you can make. And the further the market moves against you, the more your losses will stack up. Also, as you never own the physical asset, you can potentially profit from both rising and falling prices in the underlying market. In other words, you can go long or short.
You’ll see a two-way price quoted on each CFD market offered. Let’s use silver as an example. Suppose it’s currently being listed by one provider at a spread of 1650/1653 (which is the equivalent of $16.50/$16.53 in the underlying market).
- 1650 is the bid price at which you can ‘sell’ (go short)
- 1653 is the offer price at which you can ‘buy’ (go long)
If you believe the price of silver will rise, you ‘buy’ at the offer price. Or if you think it will drop, you ‘sell’ at the bid price.
You’ll be asked to put up a margin payment as a deposit to open your position. And CFDs are traded in standardised contracts, sometimes called lots. The sizes of these contracts differ depending on the asset, often mimicking how that asset is traded in the underlying markets.
Going back to silver, it’s traded in a contract size of 5000 troy ounces in the underlying market. Therefore most CFD providers also offer silver in a contract size of 5000 troy ounces. This works out to be the equivalent of $50 per pip of movement.
Overnight funding charges
When trading CFDs your provider will generally charge you a fee for holding the position overnight (unless you’re trading futures, forwards and digital 100s). These are called financing costs or funding charges, and reflect the cost of borrowing or lending the underlying asset. So, for each day your position remains open, you’ll accrue additional costs.
Why trade CFDs?
With CFDs you can:
- Go long or short
- Trade using leverage (ie trade on margin)
- Access some markets 24 hours a day
Did you know?
When trading on margin, a minimum margin level must be maintained on open positions at all times. Providers typically calculate the profit, loss and margin requirement constantly in real time and display it for their clients on screen. If the amount of money deposited drops below the minimum margin level, providers will ask for more money to cover the positions (known as a margin call), and may even close them if the losses get too large.
It’s important to remember that your losses can be higher than the deposits you make to open your positions.