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What is CFD trading? An introductory approach

What is CFD trading

Contract for Differences (CFDs) are financial contracts offered by online brokers allowing traders to speculate on the difference between the opening and closing prices of financial security, without taking physical possession of the underlying asset. In trading CFDs, the aim of the trader is to predict the price directions of the CFD assets in order to make potential profits if he predicts the correct direction. But, he stands a high risk of losing money if his prediction is wrong.

What is CFD trading? It is the business of buying and selling CFD contracts usually on broker platforms. Trading CFDs only involves trading the price movements of the financial securities by placing ‘buy’ or ‘sell’ orders; it does not involve owning the underlying asset. All contracts for difference trades are cash-settled. To become a CFD trader, you need adequate trading knowledge, trading capital or money, an internet-enabled device, and a trading account with an online broker.

To start trading CFDs as an individual, you need to find an online CFD broker; which is a financial investment firm that gives its clients access to trade CFDs via specialized softwares known as ‘trading platforms’. The major qualities to look out for in a brokerage firm is its security, regulatory status, trading platform, fees, instruments available for trading, minimum deposit, etc.

Features of CFDs

There are certain characteristics of CFDs that make them attractive to a lot of traders. Some of its salient features are listed below:

1. Leverage and margin

This is a tool that increases a trader’s exposure in multiples of the amount of money specified for trading. Margin is the amount of money required in order to open a large trade position. Every broker lists the maximum leverage and/or margin requirement it allows for each asset or asset class. For example, if a trader allows maximum leverage of 1:500 on major currency pairs. The meaning is that for every $1, the market exposure is $500. So, with a deposit of ZAR 100, you will be able to open positions totaling ZAR 50,000.

With increased capital, leverage places the trader in a position to make more profits, if the market conditions favour his trade position. But, it also increases the risk because if the market reverses against his position, leverage increases the losses and causes the trader to lose much more than he would have lost without leverage.

2. Derivative

A contract for difference is a financial derivative; meaning that it is a contract that is based on the price movements of another financial asset which is the ‘underlying asset’. For example; the equity shares of ‘British American Co. Plc’ (BAT) is listed and traded on the London Stock Exchange (LSE), UK as well as the Johannesburg Stock Exchange (JSE), South Africa. So, if you wish to buy shares of BAT and become a shareholder in the company, you can do so from the stock market; either from LSE or JSE.

But, if you are trading BAT CFDs, you are simply betting on the price direction of BAT in real-time as it is being traded in the stock market. You will not own shares of BAT but you can only trade BAT CFDs when the stock market is in session. This is because the price of BAT CFDs is derived from the stock market price of the real BAT shares.

3. Contract size

In CFD trading, each asset has its standard quantity or contract size for trading. A lot is the number of units of a financial instrument that make up the contract. For example, if you trade a standard lot of Gold CFDs, it means that you traded 100 ounces of Gold contract. For crude oil contracts; 1,000 barrels of crude oil make up a standard lot. For stocks CFDs, a standard lot is 100 units of the company shares. 100 bushels of wheat make one standard lot of wheat CFD contract. In forex trading, one standard lot is equal to 100,000 units of currency.

You can trade subdivisions of a lot as follows;

1 mini lot = 1 lot/10

1 micro lot = 1 lot/100 

4. Spread

Before you can trade CFDs, you will access the broker’s platform where the price quotes of all the assets are updated in real-time. The price of every CFD asset is quoted in pairs comprising of the ‘bid’ and the ‘ask’ price with the ask price slightly higher. The spread is obtained by calculating the difference between the ask price and the bid price. It is very important because it represents the fees paid by the trader for every transaction; hence most traders seek to trade with brokers that offer low spreads.

For example, if a broker quotes the buying and selling price of EURUSD as 1.20966 and 1.20934 respectively. So, assuming a trader decides to buy and sell one lot immediately at the quoted prices. Then,

Buy price = 100,000 X 1.20966 = 120,966

Sell price = 100,000 X 1.20934 = 120,934

Price difference = (120,966 – 120,934) = 32.

It can also be calculated from spreads as follows:

Spread = 1.20966 – 1.20934 = 0.00032 = 3.2 pips

Price difference = 0.00032 X 100,000 = 32

So the broker keeps $32 as trading fees. Spreads can be fixed or variable depending on the broker. Fixed spreads remain constant and do not change irrespective of the market conditions but floating or variable spreads widen or narrow in response to market volatility or liquidity. 

CFD Assets

The nature of CFDs has enabled it to cut across several financial markets. Since you are just forecasting if the price will go up or down, virtually all tradable financial securities are available as CFDs. Every broker lists the available CFD trading instruments on its platform. Below are the popular CFD assets classes:

Shares CFDs

The shares of the most popular companies traded on various exchanges across the world are also available as CFD instruments. Most of them come from the European and American stock markets. Examples are Apple, Facebook, Microsoft, Toyota, Shell, Tesla, Nestle, etc. The shares CFDs mirror the share price of the underlying company shares in real-time as it is being traded on the exchange where it is listed. So, assuming a trader follows the company news, reports and analysis of Microsoft Inc.; the software giant firm, he may speculate on the share price of the company via a CFD trade.

Stock indices

An index is a statistical metric used to evaluate the performance of a sector of the stock market, selected stocks or the entire stock market. For example, the FTSE 100 is an index that measures the performance of the biggest 100 companies (by market capitalization) traded on the London Stock Exchange. The value of the index is calculated in real time once the LSE is in trading session. CFD traders can predict whether the value of the FTSE 100 will go up or down by taking a buy or sell position on their broker’s trading platform. Some other popular indices are; S&P 100, DJIA, STOXX 50, DAX 30, Nikkei 225, CAC 40, etc

Commodities

These comprise of industrial raw materials and agricultural products that are sold in standardized quantities and qualities. Hard commodities are natural resources that are mined and extracted, e.g. Gold, Silver, Copper, Crude oil, natural gas. Soft commodities are agricultural products that come from the farm, e.g. wheat, coffee, cocoa, corn, cotton, etc. Most commodities are traded on futures exchanges but their CFDs are available for CFD trade on broker’s platforms. Traders can speculate on the prices of commodities and aim to profit from the price movements; but the trade can result in losses if the predictions are wrong.

Crypto CFDs

Cryptocurrencies are digital currencies that can be used anywhere in the world without central control. It is a type of digital money that has no physical form but can only be spent electronically. Generally, cryptocurrencies are created and spent over a blockchain network; which is a peer to peer decentralized database. All transactions encrypted, time-stamped and irreversible. To buy and own cryptocurrencies, you have to purchase it from a crypto exchange like Coinbase, Binance, etc. It is traded 24/7 including weekends and public holiday. Bitcoin is the most popular crypto coin; others are Ethereum, Ripple, Dash, Ether, etc.

Crypto CFDs are traded in pairs with fiat money; e.g. BTCUSD, BTCEUR, ETHUSD, XRPUSD, etc. Traders analyze and speculate on the prices of their cryptocurrency pair of choice with the aim of profiting from the price fluctuations. But, trading crypto CFDs comes with the high risk of losing money if the markets go against your CFD position.

Forex

The forex market is the international marketplace where the currencies of different nations are exchanged. It is currently the biggest financial market in the world in terms of daily volume. Individuals can trade forex through retail investor accounts maintained with online brokerages. So, forex trading is available on broker platforms on the basis of contract for difference; there is no physical exchange of the currencies and traders speculate on the exchange rates of the different currency pairs. 

CFD trading with PrimeFin

PrimeFin is an online forex and CFD brokerage brand that was founded by a team of online trading experts. The brokerage was incorporated in Malaysia but has offices in UK. It offers its clients up to 350 CFD trading instruments in stocks, indices, forex, metals, commodities and cryptocurrencies. Courtesy of its cutting-edge technology, client orders are executed in less than a second. The popular MT4 is the trading platform provided to all clients. It is fast, sophisticated and comes with the necessary tools for trading, technical analysis and risk management.

Follow the steps below to trade CFDs with PrimeFin:

  • Click on ‘open account’ and fill the registration form that displays.
  • Make a deposit into your new trading account. The minimum amount required is 3,500 ZAR.
  • Upload a copy of the requested KYC documents; ‘ID card’ and ‘utility bill’.
  • When your account is approved, download the MT4 trading platform on windows desktop pc, android or iOS device. You can also launch the MT4 WebTrader if you prefer to trade via web browser without any downloads.
  • Login to the MT4 terminal with your user ID and password.
  • On the market watch window, find the asset of your choice and initiate a buy or sell CFD position. You may use risk management tools by setting ‘stop loss’ and ‘take profit’ values. Monitor the trade.
  • When you are satisfied with the trade results, close the position. This secures your profit or loss.

Remember, CFD trading comes with high risk and you may lose part or all your trading capital. Be sure to understand how CFDs work before you embark on CFD trading. 

Advantages of CFD trading

1. Low initial capital

Trading CFDs on leverage has made it possible for anyone to have access to trade CFDs even with a paltry sum of money. For example, if you wish to buy 1 Bitcoin from a crypto exchange, you need lots of money; about $57,000. But to trade 1 Bitcoin CFD; you need a lesser amount of money which depends on the leverage offered by your broker. So, if your broker offers a leverage of 1:20, then, you only have to deposit $2,850 before you can open a position for 1 Bitcoin CFD with a trade value of $57,000. Please, note that most retail investor accounts lose money rapidly due to leverage trading. In other words, you stand a high risk of losing money when trading CFDs on leverage. 

2. Access to trade multiple instruments

One of the attractions to CFD trading is its versatility. You can trade CFDs across several financial markets simultaneously. For example, when you open a CFD trading account and deposit money into it, you can open trade positions on forex, speculate on the stock market, stock indices, crypto markets, commodities, bonds, exchange-traded funds (ETFs), etc. Multiple trades can be opened on the same platform, at the same time and from the same money deposited in the account.

3. Swift transactions and settlement

Unlike some financial markets where it takes time to execute trades and undertake physical delivery, CFDs are executed within a few seconds. It is cash-settled with all trades resulting in either a profit or loss. Once the trade is closed or terminated at a closing price, the money realized from the trade is credited into the trader’s account and it becomes available for withdrawal immediately.

4. Adequate trading tools

CFD trading is well supported with a number of online trading resources such as learning materials, numerous trading strategies, risk management techniques, indicators, trading robots, forums, etc. Many of the resources are free while some are paid subscriptions. There are several online fintech firms that provide quality analysis, market news, trading insights and other resources for those who are interested in trading CFDs.   

Disadvantages 

CFDs are high-risk investments

The ultimate aim of every trader is to predict the right market direction and place his trades accordingly in order to make potential profits. But, the markets are largely unpredictable as volatility and market reversals are common. Thus, most traders are caught up in the wrong price direction or the markets may suddenly reverse against their trades. If the losses continue, the broker issues a ‘margin call’; which is a call to action issued to the trader via email, app notifications or sms. The trader may respond by closing trade positions or adding more funds to his account. But, if he ignores the margin call, his trade position will be liquidated as soon as there is no more maintenance margin.

In fact, most brokers place it conspicuously on their websites that “CFD trading comes with a high risk and that a large number of retail investor accounts lose money when trading CFDs”.

Fees

For every trade, CFD traders pay the bid-ask spread or commissions to their broker. Some brokers may also charge additional fees such as:

  • Withdrawal fees: This applies to withdrawals and it mainly depends on the channel used and the amount of money to be withdrawn.
  • Inactivity fees: This is charged monthly from accounts that have not traded for a specific time; usually 60 or 90 days.
  • Swap fees: Applies when you maintain an open CFD trade position overnight. 

Summary

CFDs are a modern way of trading the financial markets powered by digital technology. You can easily forecast the price movement of various instruments such as stocks, indices, cryptocurrencies, commodities, forex, etc without taking ownership of the underlying assets. CFD trading is made possible by online CFD brokerage firms who present a buy price and a sell price on each of the trading instruments available. Traders will then, buy or sell the assets of their choice, thereby speculating on the price direction hoping to make profits. Trading CFDs is a big risk and often result in losses. Margin, leverage trading, spreads, contract size are some of the terms associated with trading CFDs.

PrimeFin is a well-established broker that is regulated and technologically driven. Client orders are executed in less than a second because of its cutting-edge technology. Traders are not charged any commissions on trades; rather PrimeFin incorporates its trading fees into the tight spreads presented on the MT4 trading platform. The broker supports its clients with trading tools like daily news, economic calendar and other platform tools. Also, the brokerage firm supports new and existing traders with training resources which are in form of articles, videos and eBooks. Demo account with virtual money for trading practice is freely available. 

FAQs

What is CFD trading and how does it work?

CFD trading is the profession where traders constantly analyze the financial markets and frequently trade contracts for difference via trading platforms provided by online CFD brokers. The trader only predicts the price directions of his chosen trading instruments. If he is right, he makes a potential profit, but if not, he stands a risk of losing money.  

To get involved in CFD trading, you need comprehensive trading knowledge, a trading plan, robust trading strategies and good risk management practices.

Is CFD trading safe?

CFDs are complex instruments and all CFD trades come with a high risk of losses especially if the position is leveraged. So, trading CFDs is not safe because your capital is at risk.

Why is CFD illegal?

Generally, CFDs are legal in most countries and jurisdictions except a few like the USA, Belgium, etc. For example, CFDs are illegal in USA because it was banned by the Securities and Exchange Commission (SEC). This is because they believe that citizens and residents of USA should trade on regulated exchanges and not over-the-counter derivatives like CFDs.

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