An agreement between the buyer and seller to trade financial instruments based on the price difference between the contract's opening and closing points is known as a contract for difference (CFD). Therefore; if the price is higher at the close date, the buyer profits but if the price is higher at the open date, the seller profits. This however means that when you trade a Contract for a Difference (CFD), you are agreeing to exchange the price difference of an asset from the point at which the contract is opened to when it is closed.
Some Features of contracts for difference
Short and long trading: There are always two parties to a CFD, a "long position" (the buyer) and a "short position" (the seller). Therefore Trading from the sell side is known as going short while trading from the buying side is called going long or long trading.
Leverage in CFD trading means you can gain exposure to a large position without having to commit the full cost at the outset. Although leverage makes it possible for you to spread your capital out more widely, it's crucial to remember that your profit or loss will still be determined by the total size of your position. For this reason, it is important to pay attention to the leverage ratio and make sure that you are trading within your means.
Margin means "Deposit". The ‘margin’ represents only a fraction of its total size. There are two margins in CFD trading and they are; the Deposit Margin and the Maintenance Margin. Where the deposit margin is required to open a position, the maintenance margin may be required if your trade gets close to incurring losses that the deposit margin – and any additional funds in your account – will not cover.
Other Features Related to CFD Trading
Spread - For security, the spread is the distinction between the ask and bid prices. Traders must accept the slightly lower bid price when selling and must pay the slightly higher asking price when buying. Since the difference between the bid and ask prices must be deducted from the overall profit or added to the overall loss, the spread, therefore, represents a transaction cost to the trader.
Holding costs are additional fees that a trader might pay after the market closes for the day. Depending on which way the spread is pointing, they can be positive or negative charges.
Commission fees - These are fees that CFD brokers frequently assess for trading shares.
Market data fees - These fees are charges for exposure to CFD trading services and they are expenses only related to brokers
Advantages of Trading Contracts for Difference
Easy to attract brokers across the world. This is because CFDs often come with favourable margins. So, trading in CFDs should not be a challenge to any trader who is looking forward to investing in CFDs.
The volatile international financial markets are where CFDs trade. As a result, traders have access to what is known as direct market access (DMA), which allows them to transact internationally.
On CFD trading, you have more opportunities to trade a wider range of assets such as global indices, sectors, currencies, stocks, and commodities.
CFDs traders benefit from either the rising or falling of asset prices.
On CFD trades, traders do not have to invest the full amount but rather need to open buying or selling positions on margins.
Disadvantages of CFDs
Traders Pay the Spread: CFDs present a tempting alternative to conventional markets, but they also carry potential risks. For starters, paying the spread on entries and exits takes away the chance to profit from minor changes. When compared to the underlying security, the spread also slightly reduces winning trades and slightly increases losses. Therefore, CFDs reduce traders' profits through spread costs, whereas traditional markets subject the trader to fees, rules, commissions, and higher capital requirements.
Weak Industry Regulation: The CFD market has minimal regulation. The credibility of a CFD broker is determined more by track record, longevity, and financial standing than by government affiliation or liquidity. There are great CFD brokers, but it's crucial to look into a broker's history before opening an account.
Risks: Risk is almost an inevitable factor in investing and CFD trading is not left out considering that it is a fast-moving trade that requires close observation. There are certain risks traders need to maintain and they include; liquidity risk and margins you need to maintain. In this type of risk, if you cannot cover reductions in values, your provider may close your position, and you may suffer a loss. Leverage risks and the execution risk on the other hand expose you to risks of various degrees. Where leverage risk exposes you to greater potential profits, it also attracts greater potential losses. While Execution risks also may occur due to lags in trades.
How to Trade CFDs
Now that we have taken you through the Basics of CFDs, we will now love to show you the simple ways to trade CFDs online. There are a few steps involved,
Create a Trading Account: By creating a trading account, you need to first discover a reputation CFD broker or trading platform that allows you to trade CFDs. Once you have a platform, kindly open an account providing all the required information.
Select and Download a CFD Trading Platform: Do the research and select the platform that you preferred the most to use. There are so many platforms online to try out and some of those platforms are eToro and Metatrader which are one of the most commonly used platforms. The MetaTrader platforms have advanced charting features, technical indicators, and a large support community. This platform is also among the most reliable, user-friendly, and accessible on the market, making them ideal for CFD trading.
Choose Your Trading Methodology: Now that you have selected a CFD trading platform and have opened an account, the next phase is to outline the trading methodology that will guide you as you trade. This methodology includes the routine to adopt in monitoring your trade daily and your style of trading. Do you want to be a day trader or a long-term trader, finally the market to focus on (forex, shares, or commodities). Another methodology to consider is the strategy which explains how you make your trading decision, risk management, and your support systems.
Make Your First Trade! Note; there are so many other platforms to try out. You can read below some platforms to try out, to enable you to make a better decision. Using MetaTrader as a case study to explain how to make your first trade, kindly follow the steps below to make your first trade.
Step1: Log into your trading account.
Step 2: on the left-hand side of the screen, select the 'Market Watch window.
Step3: Double-click on the instrument of your choice.
Step 4: Choose your position size
Step 5: After choosing the position size, click on 'buy' or 'sell'.
Step 6. After you have selected any of the options in step 5, your trade will now be active and saved in the 'Toolbox' window so you can always make reference to or monitor its progress.
Step 7: Whenever the market does not favour you or you have concluded your trade, you can close the trade by double-clicking the active trade and clicking the: 'Close' button
Some CFD Trading Platforms To Try Out
The following CFD trading platforms have topped our report of the industry’s best:
EToro: CFD trading on eToro offers many benefits to traders which would not be possible with traditional investing and some of these benefits include; Gaining greater exposure with less capital, Taking advantage of all market movements, and trading a variety of markets and assets. Other benefits are you can enjoy low spreads for as low as 1 pip for EUR/USD and USD/JPY, and Protect your investments with advanced risk management features, such as real-time alerts and customizable stop loss. The most interesting part is that it had dedicated customer support 24 hours a day, Monday through Friday
IG Trading: a world-leading online trading provider that gives you access to opportunities across thousands of financial markets. Why trade CFDs with IG trading? IG Trading has good risk management, effective and efficient Support system when you need it. It runs 24 hours a day, except from 6 am to 4 pm on Saturday (UTC+8). Another benefit of using the IG trading platform is that it takes your capital further by opening a position for a fraction of the cost with its competitive margins.
XTB: XTB online trading is one of the largest stock exchange-listed FX & CFD brokers in the world, providing retail traders instant access to hundreds of global markets. XTB constantly improves its trading platform to make it the best on the market.
Conclusion
After breaking down the meaning of Contract for Difference (CFD), the benefits, risks, how to trade, and some platforms to use, you can see there is a wide range of opportunities. However, just like every other investment plan, there are also risks involved. This is why; we have carefully researched this piece to help both beginners learn about CFD before venturing into it.
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