Looking for a little more adventure outside the spot forex market? Here’s a quick introduction into CFD trading and how you can profit from it.
What the heck is a CFD?
CFD stands for contract-for-difference, which is basically an agreement between two parties to pay the difference in the underlying asset’s price from its current value and its value at the time the trade is closed. This is considered a financial derivative, as it allows traders to take advantage of price movements without actually owning the asset itself.
How can you make money trading CFDs?
When you buy a CFD and the asset price goes up, you will receive the price difference multiplied by the number of units you’ve purchased. If the asset price drops, you will pay the price difference instead.
On the other hand, when you short a CFD and the asset price goes down, you will receive the difference between the closing price and opening price multiplied by the number of units you’ve purchased. If the asset price goes up, you will pay this price difference to the buyer.
Wait a minute. How is this different from forex trading?
Excellent question, young padawan! In the spot forex market, a trader essentially buys or sells a specified number of units of a currency pair at a certain price then gains or losses are determined based on the difference of the opening and closing price. Other similarities of CFDs and forex trading include OTC execution, a decentralized exchange, and some execution costs such as spread and commissions.
What sets CFDs apart from forex is that the former spans more financial markets, such as commodities and equities, which allows a trader to diversify his positions. You can speculate on global stock indices such as the S&P 500 or FTSE and trade the price of soybean against the U.S. dollar. More possibilities, more profit opportunities!
Sounds great! Where do I sign?
Hold your horses! Before forking over your hard-earned cash to trade CFDs with a broker, make sure you do more research on this type of trading instrument first. While forex trading is mostly driven by fundamental and technical factors, CFD price movements are generally influenced by supply and demand specific to the asset being traded. For example, price fluctuations for several commodities can be subject to seasonal factors while stock price trends may be dictated by earnings reports.
Make sure you also read up on how transaction costs are computed, as some asset classes are subject to commission fees while others aren’t. CFDs are also typically subject to a daily financing charge if you plan to keep trades open overnight. Margin requirements also vary among brokers so make sure you’ve properly understood the concept of leverage as well. As with forex trading, I highly encourage you to try a demo CFD account first before going live!
Is CFD trading something you’re interested in or already trying out? Share your thoughts and experiences in our comments section!