“Introduction to Contracts for Difference (CFDs) “
> Explanatory Article by Marios Kyriakou, MSc Economics
About the author: Marios Kyriakou has a bachelor’s degree in Economics from the University of Cyprus and a master’s degree in Economics from the University of Warwick. He is also a holder of CySEC’s Advanced Certificate in Financial Services Legal Framework and a professional in Online Trading, Forex and CFDs with more than 7 years of experience.
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<Last updated 14.04.2020>
Hi! If you are interested in trading CFDs online please read carefully the below article so you can be prepared and fully informed of the risks involved. You should take a look at this short article in which I explain what are CFDs.
FX and CFD Brokers
In the previous article, we have seen that Forex Brokers are financial institutions offering Forex and CFD investment services to clients worldwide. Through the trading platforms provided, clients can be participants in the financial markets online.
In particular, we are going to discuss the brokers who offer CFD (and FX) products and why it is important to understand the nature of those products.
Contracts for difference (CFDs) are derivative products that enable you to trade on the price movement of underlying financial assets (such as commodities).
It is a contract/agreement to exchange the difference in the value of an underlying financial asset from the time the contract is opened until the time at which it’s closed.
It’s important to remember that you are trading derivative contracts, with your broker and not physically trading in the underlying market.
This means you don’t actually own the underlying asset.
Trading CFD on Oil
The underlying instrument, in this case, is OIL future. Instead of buying the future, the investor buys the CFD on OIL with BID and
ASK prices similar to the price of the underlying asset.
If a tanker ship, carrying 400,000 litters of oil, sinks it creates limited supply and can cause the price of oil to rise and thus create a trading opportunity for the CFD investor.
Thus, the difference in value of the CFD is positive when closing/selling price rises. He bought low and sold higher after the incident.
You can buy CFDs for profiting from a rising price, and sell it for profiting from a falling price. (not like i.e. shares > have to be bought and then sold).
Trading CFDs involves having a margin account, you are essentially borrowing money. You pay interest on this borrowed money if carried overnight.
(overnight charge or earn from interest rate differential – Swap).
i.e. The CFD on FX pair does not have a pre-defined maturity date and is therefore considered open-ended. > CFD on EURUSD will be charged with swap according to the contract specifications.
Position Direction and Profit
Investors can find opportunities in both rising and falling markets. If they think the price is going up, they buy, and if they think it’s going down, they sell.
BID, ASK and Spread
Trading CFDs involves buying with the ASK price and selling with the BID Price.
Spread, is the difference between the ASK and the BID price. When there is high liquidity in the market, the spread is very small. Depending on the Prime Broker, or LPs, it is formed and is called RAW spread.
The higher the spread, the more you are charged for each transaction.
Tradable Asset Classes (rec2020)
CFDs enable you to trade on the price movement of underlying financial assets (such as indices, shares, cryptocurrencies and commodities).
In this way, a CFD allows you to trade nearly every underlying asset including those which are considered impossible to trade. An index, for example. Contains a large number of different stocks.
Trading 1 Dow Jones Future needs approx. 30,000 USD, since no leverage is involved.
CFDs and Leverage
CFDs offer you the opportunity to speculate on the price of such an index without having to invest such a large amount of capital.
This is where leverage come into play using a CFD. Leverage decreases the amount of capital needed for taking a position on the index.
i.e. 1 Index Dow Jones price = 30,000 USD
Leverage 1:10 means that funds required = 3,000 USD . Just 10% of the required capital (> the position value)
P.S. your profits or losses are relative to the volume of your position.
Leverage and Margin
We have seen that CFD is a leveraged product, which means you only pay a margin (collateral), which corresponds to a fraction of the actual position value.
i.e. Investor has 7,000 USD in his account. He wants to buy Index CFD 2 Dow Jones Index, with the current price of 30,000 USD.
> Position value is 60,000. The Margin Required is 6,000. When the Index price rises to 32,000 USD he closes the position.
> Profit = (Opening Price-Closing Price) x volume = (32K-30K) x 2 = 4,000 USD
Risks Trading on Margin
Trading Forex on margin carries a high level of risk, and may not be suitable for everyone. Before deciding to trade FX or any other CFD product you should carefully consider your investment objectives,
level of experience, and risk appetite.
By using leverage you use lower amount of funds but take higher risk since you amplify both Profits and losses. If the markets move against your positions, your losses will be multiplied by the leverage ratio you have selected.
Some traders opt to use a high leverage as it can multiply their profits when the markets move to the direction they have placed their position on.
This, however, leads to a higher risk of capital loss and might wipe out their funds in their account especially during periods of high market volatility.
i.e. 4,000 USD profit from a rising index price could be easily -4,000 USD instead. Loss from a falling index price. This by using 60,000 USD when in the account the investor had only 7,000 USD.
This product is classified as the one with the highest risk rank 7 out of 7. The highest risk among other products. It rates the potential losses from the future performance of the product at a very high level.
When trading on margin you are also subject to other risks. These are related to internet failure, communications failures, and delays, or account password theft.
“I hope I am clear on this one. If not, contact us on social media and we will do our best to help you.
Thank you for reading my articles and watching my videos.”