CFD Trading
What is CFD Trading and How Does it Work?
December 29, 2020
What is CFD Trading and How Does it Work?
CFD is the contract between two parties that states that one party will pay the other the difference between the current value of an asset and its value at a future date. A contract for difference thus makes it possible to “bet” on the direction of an asset (rise or fall), without holding it, and to exchange with your broker the variance in price between the opening and closing of the contract.
When we trade CFD, we never own the asset, which makes this derivative such an effective way to profit from price fluctuations of different financial instruments. This is because it is quite similar to a futures contract based on a stock or index, and as a way to trade stocks and other financial instruments.
When trading CFD, it is necessary to know the financial derivative instrument to be able to trade with a higher probability of success.
Financial derivative instruments:
A financial instrument is a contract by which we trade in a market for example bond, share, bill of exchange, futures or options contract, cheques, currency swap, drafts, or more. All the instruments serve different purposes hence the investors select instruments according to their preferences.
How does it
work?
When trading CFD, it is necessary to know the financial
instrument to be able to trade with a higher probability of success. Contracts
for Difference have become extremely popular in many countries around the
world, with the notable exception of the United States, where the Securities
Exchange Commission (SEC) still does not accept them as investment instruments
on financial markets.
It was first
established in the 1990s and was primarily used by investment funds and
institutional investors, but quickly became extremely popular with traders and
individual investors in the late 1990s.
CFD, leverage
and margin trading:
A CFD is a financial product that is often considered
complex and risky because it is based on the principle of leverage and margin
trading.
Contracts for Difference are traded based on a margin,
and in the case of equity-based CFD, the margin is usually 10%. In addition, it
is usually necessary to pay a commission of 0.1% of the face value of the
contract to open and close the position, but this varies depending upon the
broker.
What is the margin?
Margin trading permits you to borrow money from your
broker to invest more. Thus, you benefit from a leverage effect allowing you to
open a larger position than what your balance initially allows you.
Why leverage is risky?
Leverage also increases the movements of the underlying
asset it relates to. This increases your return on investment. But it also
means that when the market moves contrary to your desire, your losses are huge.
CFD trading
rules:
·
Protect your
trading capital.
·
Trading with the
money which you can bear to lose.
·
Do not burden
yourself with over-leverage.
·
You should
always know your entry and exit level before starting your trade.
·
Use a stop-loss
always, it is a fixed amount of risk that a trader will accept with each trade.
·
You should know
that how many CFDs you want to trade.
Merits of
contracts for difference:
Diversify an
allocation with little money:
With Short Selling, you can profit from a fall in price.
This technique is known under the name o
Leverage helps you, without having to lock in an important money, to multiply your initial investment (as well as your gains or losses) and thereby trade a complete portfolio of stocks, indexes or commodities
Selling Short:
You will benefit from a price decline. This strategy is known as defense or hedging. It is especially beneficial to hedge a stock portfolio against a decline in the economy.
Zero stock
market tax:
CFD does not give
any ownership rights and is not considered to be securities. You, therefore, do
not pay capital gains tax on the sale of securities, because there is no
physical purchase.
Gain and Loss –
How does it work?
If your market situation is correct and the market is
heading in the expected direction, your broker will pay you the difference
between the opening and closing your trading position. It is then a profit,
which would be added to your account balance.
With
Contracts for Difference, it is just as easy to open a short position (short
sale), whereby the trader receives a nominal amount of interest on his account.
Another aspect that should be taken into consideration with CFD is that while
the position is open, they are exposed to the market daily. This can cause the
trader to suffer a heavy loss.
If you are not aware of the basic mechanism, you should
not select CFD. You need to understand the fundamentals of trading in the
markets.
