Noah from Germany

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What are CFDs and How Do They Work?

A CFD is essentially a financial arrangement between two traders where the ownership of an asset does not necessarily change hands, but the buyer and the seller in this scenario take part in the transactions purely based on the share price movement. The transactions are not based on the stock itself. Therefore, if there is an increase in the share price during the CFD, then the seller will have to pay the buyer the price difference.

However, if at the close of the trade the share price falls below when by the close of the trade, the buyer must pay the seller the difference in the price. Just like before, there is no transfer of shares during the trade, only the monetary change in the value.

What does CFD stand for? CFD is an abbreviation for Contract for Difference but it is mostly used in its abbreviated form.

What is trading with CFDs?

CFD trading is the buying and selling of CFDs, CFDs here being the derivative product since they can help traders speculate on financial markets like indices and commodities, forex and shares without taking ownership of the assets in question.

Therefore, to have a better understanding of how CFDs work, you first need to understand a few fundamental concepts behind the operation of CFDs. These are:
Leveraging
Hedging
Margins
Short and long trading

Leveraging

Leveraging in CFD trading, fundamentally means that as a trader, you can easily gain some exposure to a larger position without the need to commit the costs in full at the end. For instance, if you wanted to open a position that is equal to 500 Google shares, you will have to pay the costs in full upfront in a standard trade. However, for CFDs, the cost you might have to put up might just be about 5% of it.

Even though if you choose to leverage you could possibly spread your capital further, you should understand that the calculation of your profits or losses will be based on your position’s full size. Using the same example, this will be the price difference in the 500 Google shares from when you opened your trade to the outset. What does this mean? Your losses could exceed the deposits or the profits and losses could tremendously be magnified against your output. That is why you need to pay special attention to the leverage ratio by keeping your trades within your means.

Hedging

You can also use CFDs to hedge against losses to a portfolio that is already existing. This means that if you anticipate that your portfolio might suffer a dip shortly because of some earning report that was seemingly disappointing, you could choose to offset any possible losses by short selling a CFD trade. This decision will make your portfolio gain as a result of any drop in the value of the shares in question.

Margins

When you leverage a trade, you are basically trading on a margin. Two important aspects to understand here are deposit margins and maintenance margins. A deposit margin is the fraction of the total size that you need to open a position whereas a maintenance margin might come in handy in case your trade comes close to incurring losses that your deposit margin or additional funds may not cover.

Short and long trading

Shorting or short selling is a strategy that you can use to gain a competitive edge over the falling markets in price. In other words, you sell a borrowed asset hoping that the market price will take a dip then buy back the asset for a profit, the opposite is also true for long trading. That is why CFDs are the best tools for shorting. Short selling is not allowed in many countries for this reason, but it is acceptable by law in the UK. Either way, losses or profits will b realised that the outset.

Reasons for short-selling

There are a number of reasons why you can choose to short sell, with the primary one being to increase your number of trading opportunities. You should try short selling because of the following major reasons:

Speculation

If you decide to short sell, you will create a new dimension or market movements that you will be able to speculate on. As an individual trader, you can make more profits despite the price drop for the underlying asset.
Hedging: As an individual trader, you have the chance of protecting yourself against potential losses when you take a long position. Hedging helps lessen the impact of losses.
Stay active: You can also remain active even when the prevailing economic conditions are tough.
Take advantage: The main reason why you would choose to short trade is to take advantage of the plummeting value of the stock.

How does CFDs work for Individual Traders

Now that you have some understanding of what CFDs are and some of the underlying concepts, it is now time to move to the next step. Some of the questions you may be having could include how to trade CFDs, can i trade cfd's from home risks with CFDs safe to trade, going short with CFDs among others. Not to worry, the following section will cover all that.

Commission and spread

There are two prices when talking about CFDs; the buy price and sell price. The buy price is the price you use to open a long CFD whereas a sell price is a price that you can use of open a short. It is important to note that the sell price is often lower than the prevailing market price and vice versa for the buy price. What is referred to as the spread is the difference between these two.

In most cases, the spread will cover the costs of opening a CFD position. However, when the sell price and buy price match the prevailing market price for opening a CFD position, the charge will be commission-based.

Deal size

You can trade CFDs in standardized contracts known as lots. The size of a market may vary depending on the asset being traded. This, in most cases, mimics how traders are trading that asset on the market. The deal size is why more individual traders prefer trading with CFDs. They are more or less similar to conventional trading.

Duration

Another queer way that CFDs work is that they don’t have a fixed expiry. You can choose to close a position by placing a trade in the exact opposite direction to the trade that opened that position. This means that if you decide to keep your CFD position open daily, past the cut-off time, there will be an overnight funding charge on your account. Typically, the cut-off time is 10 pm UK time.

Profit and loss
In order to calculate your CFD trade profits, you need to multiply your position’s deal size by each of the contracts then multiply the result with the difference in price points at the time of opening and closing the contract. To get the full calculation, you need to subtract any fees or charges paid like guaranteed stop fees, commission or overnight funding charges.

Are CFDs safe to trade?

When talking about the safety of CFD trade, the first thing that should come to mind is your broker. If you want to enjoy your time CFD trading, first of all, find a broker that is fully licensed and regulated.

In general sense, CFD trading is relatively riskier than any other trade. However, this does not mean that it is not safe to trade CFDs. CFD trading is just a derivative of conventional trading that gives you the chance to trade in several markets globally by just using one account. Provided that you know how to calculate and work the risks involved, you will reap from it while being assured of fair play.

However, take note that choosing to leverage at the initial stages of CFD trading might not be the best way to go for you because that will be risking too much without really understanding what it is about. This is because the final outcome in CFD trading can be challenging to predict until the outset of the trade.

Which instruments work best for CFDs?

The following are some of the best CFD trading instruments you can use to make the most out of CFD trading:

EURAUD
AUDUSD
GBPAUD
USDJPY
EURCHF

Where is the spread lowest

Some of the best brokers that offer the lowest spread for the above-mentioned instruments include:
[MORE INFO SOON].

How can I trade with CFDs profitably?

The ability to make profits consistently with CFDs is something that you learn over time. However, there are some preliminary steps that you can take to give you a head start in the right direction.

Choose the best market: Decide on your preferred market before you start trading.
Decide to buy or sell: The trick here is sell, sell, sell. The best way is to short sell to get the best results.
Select your deal size: Consider the bulk of CFDs that you are willing to trade.
Add a stop loss: This will help you close your position if the market price stops favouring you.
Monitor then close your trade: Keep a close eye on your trades in real-time. If it is not in your favour, just exit the trade.

What are the biggest risks with CFD trading?

Some of the potential risks that you can face while CFD trading include:

Market volatility and gapping: Gapping often arises because of market volatility. It is often caused by sudden shifts in the prices of the selected instruments. This can result to stop-loss orders, which might happen at unfavourable prices. You can mitigate the risk by applying a guaranteed stop-loss order or order boundary.

Account close-out: Rapid market shifts might result in the changes in your account balances. Without funds to cover such occurrences, your positions could easily be closed and may lead to the closure of your account. Always keep an eye out and close positions or deposit additional funds to prevent this.

Holding costs: These are costs that you may incur depending on the duration you hold a position. In some platforms, if you hold a position for too long, your profits might be exceeded by the holding costs. Always ensure that you have sufficient funds. This will ensure that all your holding costs are covered.