What is a contract for difference (CFD)?
A contract for difference (CFD) is a type of financial derivative in finance. This guide has everything you need to know about CFD trading explained in simple terms.
So what does CFD mean in trading? CFDs allow you to speculate on various financial markets, including cryptocurrencies, stocks, indices, commodities and forex pairs. You never buy the assets, but speculate on the rise or fall in their price, usually over a short period of time.
A CFD is a contract between a broker and a trader who agree to exchange the difference in value of an underlying asset between the beginning and the end of the contract, often less than one day.
A contract for difference (CFD) is:
- A derivative – you do not own the underlying asset
- An agreement between you and your broker
- Based on the change in an asset's price
- Conducted over a short time period
What are CFDs?
A contract for difference (CFD) lets you trade using just a fraction of the value of your trade, which is known as trading on margin, or leveraged trading. This allows traders to open larger positions than their initial capital may otherwise allow. Therefore, CFD trading offers greater exposure to global financial markets.
One of the benefits of CFD trading is that you can speculate on the asset’s price movements in either direction. You buy or sell a contract depending on whether you believe the asset’s price will go up or down, opening a long or a short trade, accordingly.
You should know that leverage trading can amplify your profits, but can also boost your losses.
How does CFD trading work?
When you open a contracts for difference (CFD) position, you select the number of contracts (the trade size) you would like to buy or sell. Your profit will rise in line with each point the market moves in your favour. Although, there is a risk of loss if the market moves against you.
Buy
If you think the price of an asset will rise, you would open a long (buy) position, profiting if the asset price rises in line with your expectations. However, you would risk making a loss if the asset price falls.
Sell
If you think the price of an asset will fall, you would open a short (sell) position, profiting if it falls in line with your prediction. However, once again, you would be risking making a loss if the asset price rise.
What is a CFD account?
A contract for difference (CFD) account enables you to trade on the price difference of various underlying assets using leverage. Leverage means you put up only a fraction of the amount needed to trade. This is called deposit margin.
Meanwhile, the maintenance margin (required margin) needs to be covered by equity, which is the account's balance that includes unrealised profits and losses. The maintenance margin goes up and down depending on the prices of assets you are trading. Your account’s equity must always cover the maintenance margin to keep the positions open, especially in case of running losses. Otherwise, you risk receiving a margin call.
Often you can learn to trade in a demo account, but you will need to add funds to create a CFD trading account before you can trade live.
Some regulators require that new customers pass an ‘appropriateness or suitability’ test. This often means answering some questions to demonstrate that you understand the risks of trading on margin. It’s best to thoroughly educate yourself on how leverage and margin work before trading.