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February 2, 2016

Understanding the Basics of CFD Trading

Many people nowadays hear a lot being said about the benefits and potential profit involved in CFD trading and can’t help but be intrigued by it. On the surface it certainly sounds appealing enough – and claims to be able to let you make trades without owning the underlying instrument itself, or even having to cover its entire cost.

If you are really interested in getting into CFD trading however, it is important that you understand its basics – including what it is and how it all works.

“What is CFD Trading?”

Essentially CFD trading is short for ‘Contract for Difference’ trading and it is structured as an agreement between two parties to exchange the difference between the opening and closing price of a contract.

Unless you have a background in finance that may sound a bit confusing – which is why it is best to think of CFD trading as attempting to predict whether a certain instrument is going to rise or fall in value. Based on your prediction, you can then use CFD trading to take a position that will allow you to profit from it should your prediction turn out to be right.

“How Does a CFD Work?”

To use CFD trading, you need to decide whether to ‘go short’ or ‘go long’. If you choose to ‘go short’ it means that you think the price of the instrument is going to fall, and as such you’re going to sell at its initial value. On the other hand if you decide to ‘go long’ then that means you think the instrument is going to rise in value, and so you’re going to purchase it instead.

With a CFD you don’t actually ‘sell’ or ‘buy’ the instrument itself, instead you only make an agreement to do so and profit (or loss) from the difference in price at the end of the period agreed upon. For example:

  • Initial price is $1
  • Closing price is $1.20
  • Difference is +$0.20
  • If you had decided to ‘go short’ you would make a $0.20 loss per CFD.
  • If you had decided to ‘go long’ you would make a $0.20 profit per CFD.

“What Makes CFDs So Attractive?”

While there are many reasons why CFD trading is currently so popular, for the most part it boils down to the fact that it really is quite simple and it has a very high leverage. Essentially you’re simply going to be predicting whether a position is going to rise or fall in value – which is something that most people find appealing.

Also you will never have to pay the total trade value to make a trade due to the leveraged nature, and instead only pay a certain margin upfront. Needless to say this allows you to make bigger trades than otherwise, but it also exposes you to more risk.

Long story short, CFD trading does have a lot of potential – and now that you understand how it works you should be able to look into getting into it and start making a profit of your very own.  

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The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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