What Is CFD Trading and How Does It Work?

Nowadays, CFD (Contract for difference) trading has become one of the most popular ways to get involved in the financial markets. It stands out with its great flexibility, allowing investors to enter the trade without owning the underlying asset. If you have been hesitating whether to add CFDs to your existing portfolio, read on and find out everything about this financial product in our article: key features, definitions, CFD advantages and disadvantages, trading examples, and much more.

What Is CFD Trading?

CFD trading is the process of speculating CFDs or Contracts for Difference. It lets investors take advantage of the asset price movements between the entry and exit trades. CFD, in turn, is an agreement between a buyer and a seller that implies that they have to exchange the difference in asset price between its current value and the price at the contract time.

CFD trading has gained ever-growing popularity due to some of its key features. Let’s have a closer look at them.

1. No ownership. When trading CFDs, a trader doesn’t own a physical asset. He takes profit or loss due to price changes of the underlying instrument.
2. Big choice of markets. CFD trading is available on around 15 000 different markets, including stocks, shares, cryptocurrencies, forex, commodities, indices, etc.
3. Leverage. Leverage allows CFD traders to open the trade, paying only the margin (a percentage of the asset’s full value).

What Instruments Can Be Traded As CFDs?

CFD trading offers investors a big choice of financial assets to work with. Here are some of them.

• Stocks (also known as equities or shares) are assets representing the ownership of a company’s part. For example, Facebook stock - FB, Apple stock - AAPL, etc.
• Currency pairs are two national currencies quoted against each other. The most traded pairs include EUR/USD, USD/JPY, AUD/USD, etc.
• Cryptocurrencies represent digital money and are gaining growing popularity nowadays. The most well-known examples of crypto are Bitcoin (BTC), Litecoin (LTC), Ethereum (ETH), etc.
• Indices are baskets of securities that are used to measure the performance of a particular financial market. The three most common indices involve S&P500, Nasdaq, and Dow Jones.
• Commodities represent the most important goods in commerce, such as gold, crude oil, coffee, etc.
• Bonds are debt securities issued by governments, municipalities, or corporations.

How Does CFD Trading Work?

When trading CFDs an investor doesn’t buy or sell the physical asset, he speculates on its price, trying to predict whether it will rise or drop. The first thing he has to do is to decide on the asset type (forex currency pairs, stocks, crypto, etc.) and define such parameters as the number of contracts he wants to trade, leverage, stop-loss and take-profit orders, etc. Then, the trader and the CFD broker sign the contract, setting the asset opening price and discussing extra fees if necessary. Once the position is open it stays so until the time the investor decides to close it.

The trader wins if his expectations on the price changes are correct. In such a situation, the broker pays him the difference. In case the market turns in the opposite direction and the trader closes at a loss, he is charged for the difference between the opening and the closing price.

What Is Short and Long CFD Trading?

CFDs let investors speculate on price movements in either direction, meaning that it’s possible to take profit even from the falling market. When expecting the asset price to grow, they can open a “Buy” or long position. And, conversely, thinking that the asset price is likely to decrease in value, they can open the “Sell” or short position. The possibility of going both long and short is one of the greatest advantages of CFD trading.

Going Long Example

A trader believes that the stock of the fictional company “XXX” is going to grow and decides to take advantage of this trading opportunity by going long. He wants to buy 1000 stocks at $50 per share, thus the total value of this underlying asset will be 1000*$50 = $50000. However, using CFDs, he doesn’t need to put it in all. Let’s say that the leverage is 30:1, then to open this position, the trader needs to pay the margin of 3.3%, in our case 1000*$50*3.3%=$1650.

Winning case:
If the trader’s expectations are correct and the price for this stock grows to $55 per share, his profit will be ($55-$50)*1000=$5000.

Losing case:
The stock price starts to continuously drop in value at odds with the trader’s expectations. So, to avoid drastic losses he decides to close the trade at $45 per stock. In this situation, his loss will be ($50-$45)*1000=$5000.

Going Short Example

A trader supposes that the fictional company “XXX” will stop doing well in the market, so he decides to open a short position. If all conditions are the same, he needs to invest $1650.

Winning case:
The predictions are correct and the asset price goes down to $45. In this case, a CFD trader short-sells and gets the profit of ($50-$45)*1000=$5000.

Losing case:
In contrast to trader’s predictions company “XXX” shows seamless results at the end of the quarter, which makes its shares go up in price. Therefore, he closes the trade at $55 per stock, running a loss of ($55-$50)*1000=$5000.

It’s crucial to remember that in both short and long positions, the loss may exceed the amount of the initial investment. This is because of the leverage. Being calculated based on the total asset value, it can magnify not only the profits but also the losses.

What Is Leverage in CFD Trading?

Leverage is an instrument that provides traders with improved control over the market. It means that they need to pay only a small fraction of the total amount of the position and can spread the rest of their capital over other trades.
CFD trading comes with higher leverage in contrast to other trading ways. Its amount may differ, depending on the market regulations and the broker. Yet, it’s usually kept between the 30:1 to 2:1 range, being associated with the margin from 3% to 50% accordingly. For example, if a trader wants to open a position worth $10000, with a leverage of 10% he has to put in only $1000. However, it’s crucial to remember that leverage increases both profits and losses. Thus, the higher the leverage the higher is the risk of losing more than the initial capital outlay.

What Is Margin in CFD Stocks Trading?

Margin is collateral (percentage of the position total value) that a trader needs to invest to cover the broker’s credit risk and enter the trade. It reflects the leverage, meaning that if the leverage is 5:1, the margin will be 20%. Thus, the investor has to provide only 20% of the position value, the rest will be covered by the broker.

Margin Trading Example

Let’s say that a CFD trader wants to buy 100 Facebook stock (FB) at $320 per share. The total position value will account for $320100=$32000. However, if the margin is 20%, he needs to invest $3200020%=$6400. If FB stock price goes up to $325, the speculator can close the trade with a profit of ($325-$320)*100=$500, or vice versa, the price goes down and the trader closes at a loss.

What is the Contract Length of CFDs

Contract for difference doesn’t have a fixed expiration date. It lasts until reaching the stop-limit or take-profit order or until the time a trader decides to close his CFD position by opening the opposite trade to the one he had. For instance, if the investor had a short position for 100 Apple stocks, to close it he needs to open a buying trade for that asset.
What’s more, it’s necessary to remember that if you keep your position open overnight, you’ll have to pay an overnight (rollover) fee. It’s an amount based on the position value which is calculated daily.

Profit and Loss

A CFD trader reaps profits if his predictions for the asset price change are correct and suffers losses if his expectations haven’t been fulfilled. To calculate the profit or loss size an investor needs to find the difference between the open and close trade value and multiply this amount by the number of CFDs traded. For example, a trader opens a buy position of 100 contracts when the asset price is $20 per share. If the asset value increases to $30, he will win ($30-$20)*100=$1000. If the asset price decrease to $15, the trader will run a loss of ($15-$20)*100= -$500.

Hedging Your Portfolio With CFD Trading

While hedging is a widespread risk management strategy, helping investors mitigate potential losses, CFD is one of its efficient instruments. Its main goal is to offset the price movements in an opposite position and/or in a different asset. It means that by opening a CFD trade a speculator will still gain profit even if his other position starts to lose.
For example, a trader holds some Amazon shares and wants to keep them for a long period. However, he is expecting their slight drop in value on a short distance. This is when he can open a short position via CFDs. This way, if Amazon stock goes down a trader will compensate the loss in his main portfolio by a successful CFD trade. In case his expectations were wrong and Amazon shares go up, he will lose in his CFD trade but will take profit from his opposite position.

What Are the Pros of CFD Trading?

The key benefits of CFD trading include but are not limited to:

1. Flexibility. Not only do CFDs allow traders to increase their market exposure but also provide them with a great variety of financial instruments to trade.
2. High leverage. CFDs come with higher leverage in contrast to other trading products. Speculators need a lower investment to enter the market, thus, they can use the rest of their capital to diversify the portfolio.
3. No expiration date. CFD trade remains open until the investor decides to close it or until the time it reaches the stop-loss or take-profit order.
4. No restrictions on shorting. CFD traders can take advantage of both rising and falling markets. They can open either long (buy) or short (sell) positions.
5. Hedging. CFD is a robust tool to mitigate risks. If an investor expects that the market can turn against his opened position he can place the opposite trade in CFDs, this way offsetting potential losses.
6. Cost-efficiency. When trading Contracts for Difference traders don’t have to pay the stamp duty. Moreover, the broker fees are usually lower than in traditional trading.

What Are the Cons of CFD Trading?

To take full advantage of CFD trading it’s necessary to be aware of its drawbacks. Here are the most common of them.

1. Leverage. It’s considered as both an advantage and a disadvantage. Higher leverage implies not only improved profits but also increased losses.
2. Geography limitations. CFDs are traded over the counter (OTC). Thus, they are not allowed in some countries, for example, in the US.
3. Fewer regulations. This can also be a double-edged sword. On the one hand, it means that CFDs have fewer investment conditions, so it’s easier to open an account and enter the market. However, on the other hand, it implies that traders have to be more careful when looking for a suitable broker.

Why Trade CFDs With NAGA?

Naga is a trustworthy and efficient social trading platform, standing out among its competitors with a vast number of benefits.

• Huge community. Naga binds together more than 1 million traders. You can follow them, learn from them, and even copy their trading behavior.
• Big choice of assets to trade. On this platform, customers can trade more than 950 different financial products, including CFDs.
• Autocopy feature. With Naga, you can mirror the trading strategies of other CFD investors.
• Platform support. Naga supports MT4, MT5, and NAGA Web Trader. What’s more, it is also available as an app for Android and iOS systems.
• Multiple payment options. To make a deposit it’s possible to use a credit or debit card, IBAN account, Virtual Naga card, e-wallets like Skrill and Neteller.
• Market news. Being a social trading platform, Naga provides its clients with access to the latest financial news.

Conclusion

CFD trading is not much different from other financial instruments. However, to take full advantage of this product it’s important to be aware of its key features and risks. CFDs offer investors bigger market exposure, higher leverage, little fees, no ownership over the underlying asset. On the downside, they are less regulated and come with increased
potential risk due to the higher leverage.

It’s also necessary to keep in mind that much of the CFD trading success depends on the choice of the broker. Naga is a robust, safe, and cost-efficient platform that will provide you with a big choice of advanced trading tools.