What is a CFD and how it works

CFD stands for Contract for Difference. A CFD is a derivative financial instrument or simply a derivative product. A CFD is called a derivative because it derives its value and performance from one or more underlying assets (for example shares, indices, commodities, currencies or bonds).

What is CFD Trading? CFD trading is characterized by the trader speculating on rising or falling prices in international financial markets or on individual financial products. If the predictions are correct, it is possible to make a profit based on the difference between the prices of the underlying asset when buying and selling the CFD. As an investor, you can also use CFDs to hedge an existing physical portfolio with contracts for difference with unlimited maturity.

The advantages of CFDs

CFDs have considerable advantages which explain why this instrument is so successful among traders and is spreading with an increasing trend:

they allow you to maximize the initial purchasing power by paying only a small percentage, thanks to the financial leverage that allows you to negotiate expensive products with small sums;

they allow you to generate profit both when the market is rising and when it is falling, since it is possible to operate both long (buy) and short (sell). Attention: these operations are to be considered risky and capable of generating losses for the trader, especially if he is not familiar with the broker or the instrument with which he has chosen to trade. CFDs on shares are available in the UK, USA and Europe and it is possible to trade CFDs on stocks, stock indices, currencies, commodities and much more.

CFD trading: what are the risks?

CFDs are leveraged products, which means that traders only deposit a small percentage of the full value of a trade to open a position. This is referred to as trading on margin. In practice, a trader can deposit a small amount of money against a much larger investment, and in this way it is possible to amplify the potential return on the investment. But, crucially, the process also works in reverse: the losses suffered will increase in a similar way.

The result is that, instead of just the cost of the initial bet, a trader who backs a stock incorrectly could potentially lose all the money deposited in the CFD provider broker’s account. For example, a €100 bet on the price of oil going up could lead to a loss of more than €100 if the price of oil goes down. The lower the price of oil falls, the more money the trader is likely to lose. If a trader were to lose €500 with such a prediction and had at least €500 deposited on the CFD trading platform, he would lose all €500 not just the €100 stake.

What is margin in CFDs

The capital required by a trader in his account and to open and maintain a leveraged position is referred to as margin. Margin is typically presented as a percentage of the total trade size, and the amount required varies from market to market.

To open a position on the foreign exchange (forex) market, a CFD trader may need to have 5% of the value in their account. To open a position on the stock you may need a larger amount, between 25 and 30% of the total transaction.

For example, buying five oil CFDs at €5,325 would give you a total position of (5×5,325) €26,625. If oil requires a 10% margin, the trader will need 10% of €26,625, or €2,662.50 in his account to be able to trade.

How do you make money with CFDs?

What determines returns in CFD trading? Instead of choosing the amount of an asset you want to invest in, such as 100 Enel shares, in CFD trading you choose the number of contracts to buy or sell. If the market moves in the trader’s favor, he will make money; if it moves against, he will lose. Profits and losses are realized when the position is closed out and contracts purchased at the start of trades are sold.

As with traditional stock trading, the return on a trade is determined by the size of the investor’s position and the number of points the market in question has moved. For example, suppose you buy 100 CFDs on Eni shares for €500 and then sell them for €550. If in this case the gain would be 50 euros. If the CFDs had been sold for €450, the loss would have been €50. As CFD trading involves price movements rather than ownership of an underlying asset, investors are exempt from stamp duty and pay no commissions of any kind.

What are the costs of trading CFDs?

CFD traders need to consider these main costs:

  • The spread, or the difference between the buy and ask prices. The presence of a spread means that a trade must move a certain amount in a positive direction before a trader can resell it at the price paid. Spreads are typically low, but it’s worth comparing between brokers.
  • Commissions. Some brokers claim that their platforms allow commission-free trading. However, they may charge higher spreads to justify this condition, which makes it all the more important to consider the overall cost of the expected commissions before choosing the broker. It is also quite common for a fee to be charged, usually a fraction of a percentage point of the value of the underlying security when a trade is executed. Sometimes a commission is not charged when trading indices rather than individual stocks.
  • Overnight fees, which is an interest charge that is charged when a position is held overnight, and this is done at a previously agreed rate. Traders who take short rather than long positions can receive interest on the value of a trade. The interest rate paid will be indicated before opening the position.

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