CFD trading is a type of derivative since it involves the speculation of how an underlying asset will perform over a given time period and not any ownership of that asset. In other words, the value of the trade derives from the performance of that underlying commodity, share price, bond or currency pair. The outcome of a CFD trade will either be a profit or a loss and which one it is will depend on whether the trader speculated correctly or not. There are two positions that a trader can open a trade at; long or short.
If it is believed that an asset value is due to increase then the trader would ‘buy’ or go ‘long’. If the belief is that the asset to which the CFD is tied to (underlying asset) will decrease in value, then the trader would go ‘short’ or ‘sell’. The amount of profit (or loss) achieved by the CFD trade, will be directly proportional to the number of points moved in either direction.
What Does CFD Stand For?
CFD stands for Contract for Difference and the contract is the agreement between two parties about the movement in value, of an asset. The two parties are the broker and the trader and it is the trader who makes the judgement on whether the asset value will increase or decrease. The Contract for Difference holds that at the end of the contract when the trade ‘closes’, the trader will either have speculated correctly and made a profit, or got it wrong and suffered a loss. The trader has effectively sold the virtual value of the asset, to the trader, and the contract dictates that they must virtually buy back the asset at the end. As an example, the trader goes short on £10 shares valuing £1000 and the value of these shares drops to £500 by the end of the CFD (£5). The broker is bound by contract to sell them back to the trader and the trader is bound to buy them back. In the above scenario, the trader is in profit to the tune of the difference between when they sold and when they bought. So no asset is traded, but rather the difference between two values of that asset at two distinct points in time.
What Fees Do CFD Brokers Charge?
One of the benefits of CFD trading is that brokers do not charge fees unlike share dealing. However, they charge a ‘spread’, which is an amount of pips or points on the bid (sell) price in the opposite direction to the trade so that the bid price would not be the actual £10, but £10.50. This means that the overall value of the underlying asset would have to drop by more than £50 just to break even.
What is Margin?
Margin is another benefit of the CFD trade. It allows for leverage since only a small percentage of the actual trade value is required to trade, compared to buying and selling shares which demands 100% exposure to the risk. The margin on a CFD trade is typically around 5% which is very low and allows traders to place large value trades with a relatively small amount of cash. However, 100% of the profit, plus margin is due to successful traders, in the same way as 100% of any losses are also due.
What are the Other benefits of trading CFDs?
CFD trade profits do not attract stamp duty in the UK at the point this article went to print, although one is advised to regularly check tax laws as they can be changed at any time. CFDs can be used as a hedging tool to offset losses suffered by a physical stock holding by going short during periods when that stock value is expected to drop. Since CFD trades are strictly hinged on asset value movements only, one can trade whether markets are rising or falling.
How do I Start trading
Doing some background research is a must for those new to trading CFDs and it is recommended that a reputable broker, or other credible brokers, are approached for more information. These large firms have highly advanced trading platforms and provide access to all of the main markets. They also offer demo accounts where you can practice with toy money before making your first live trade.