You must understand how CFD trades work if you desire to make profits from trading them.
What is CFD?
A CFD (Contract of Difference) is a leveraged ‘derivative’ investment instrument,
The CFDs are classified as derivatives because their value is derived from an asset.
The trading goal is to profit from the change in the value of the underlying asset over time.
Trading CFDs enables you to trade both ‘long’ and ‘short’.
‘Trading long’ means to buy a CFD with the prediction that the underlying asset will increase in value.
‘Trading short’ means that a CFD will be sold with the prediction that the underlying asset will decrease in value.
If the price of the asset rises and you close out your CFD, the seller,(CFDs Broker), will pay you the difference between the current price of the shares and the price when you took out the contract.
CFDs are not subject to an expiry date such as options or futures contracts. To close a CFD trade, you would need to make a second trade that will be a ‘reverse’ trade of the first.
What is ‘leverage’?
These small differences can have a huge impact on how much you earn or how much you lose.
CFDs Trading allows you to speculate an asset’s rise or fall depending on its movement. For example, it’s possible to bet a few cents on the value of a share or bet a few thousand pounds on a currency. CFDs brokers provide leverage to your trade to increase the potential profit. With CFDs, you only put in a small amount, sometimes as little as 1%, and the exchange takes care of the remaining 99%. Even if you only put up 1% of the value, you are entitled to the same gains or losses as if you made 100%. The actual percentage of the market value you are required to put in for CFDs and other underlying assets will vary for UK CFD providers. Those advantages make CFDs trading very attractive. Even if you don’t have the money to buy the underlying asset itself, you can share in potential gains and losses on the value of that asset. But since the leverage magnifies the profits and losses, the risks are magnified proportionally. You might end up losing much more than what you put in.
How is trading CFDs different from traditional trading.
Unlike trading financial assets, when you trade CFDs, you are not buying or selling the underlying asset. What you purchase is a contract between yourself and the CFD Broker. Because all you own is a contract with the CFD provider, you must be sure that the CFD broker is in a sound financial position and will be able to meet their obligations to you.
What do you mean by the term underlying asset?
When Trading CFD, you agree to trade the difference in the value of an underlying asset between now and a future date.
UK CFD brokers enable you to trade CFDs on a range of underlying assets. Shares are the most common underlying asset. But most UK CFD providers also allow you to trade CFDs on other underlying assets, such as commodities and foreign exchange (FX), cryptocurrencies and market indices.
Example of a CFD trade
The current price of a CFD over X shares offered by the CFD provider is $5.
You log into his CFD trading account and places an order to buy 5,000 X CFDs at $5 per CFD.
The total contract value is $5 x 5,000 = $25,000.
The CFD broker requires a 5% margin to open a trade.
The margin is equal to $25,000 x 5% = $1,250