What is CFD
CFD or Contract for difference is an agreement between two parties, buyer and seller. The value of the contract is based on the underlying asset (for example, index, stock or commodity futures). Upon the contract expiration or when the parties make a decision to close the position, the seller pays the buyer the difference between the current value of the asset and its opening value, if the value of the underlying asset has increased. And, vice versa, if the value of the underlying asset has decreased, and the difference between the current and initial value of the contract is negative - the buyer pays it to the seller.
CFDs are derivative financial instruments by their nature that provide traders with an opportunity to make profit on price movements of various assets, allowing opening long positions when the asset prices go up and short positions, when the prices go down. The CFD value linked to the underlying asset moves in the same direction as the price of the underlying asset and depends on the same factors. At the same time being much more flexible and accessible, contracts for difference present a number of advantages, such as low cost, trading with leverage and market diversification, compared to trading the underlying asset directly.
If you are still asking “What is a CFD?” it is worth to bring an example that will help you to imagine it in practice. Let's say the initial price of Apple stocks is $100. You conclude (buy) a CFD contract for 1000 Apple stocks. If the price then goes up to $105, the sum of the difference, paid to the buyer by the seller will equal to $5,000. And vice versa, if the price falls to $95, the seller will get the price difference from the buyer equal to $5,000.
The contract does not imply physical ownership or purchase/sale of the underlying stocks that enables investors to avoid the registration of the ownership rights for the assets and the associated transaction costs.
How CFDs work
CFD imitates the profit and loss for real purchase or sale of an asset. The contract provides an opportunity for trading in the underlying market and make a profit without actually owning the asset.
Let us assume that you expect the rally in metals market to continue and you want to buy 1000 stocks of Freeport-McMoRan Copper & Gold Inc. (FCX), the world's largest publicly traded copper producer. You can buy these stocks through a broker paying a considerable portion (according to the regulatory norms of the Federal Reserve, the initial margin is currently 50% in the U.S.) of the total value of these stocks and take a leverage from the broker for the other part and, moreover, to pay commission to the broker.
Instead, you can buy CFD contract for 1000 FCX stocks. To buy this contract you would have to make much lower margin deposit (2.5% of the total value of stocks provided by IFC Markets).
The question “what is CFD trading?” is the most frequent one among beginner traders, who are just starting out in online trading. CFD is a versatile investment instrument and it is traded by the same method as currencies are done.
Alongside with these instruments, IFC Markets has developed new types of CFDs - Continuous CFDs, i.e. contracts that do not have expiration dates. These Continuous CFDs imply that investors themselves decide the dates for closing the contract and taking the profit/ loss. Besides, several below mentioned opportunities make the contracts for difference ideal instruments for online trading.
Margin trading allows to take a higher position volume in the market by a small sum of the invested capital. When the market moves according to your expected direction the profit increases by the provided leverage, since you had deposited only a part of the total contract value but the profit will be made from the change of the total value. Conversely, in margin trading losses may also increase in case the market goes against your expected direction. That is why it is important to be careful when trading with a leverage: risk management becomes highly important.
Day trading is defined as the process of buying and selling various assets within the same trading day. This means that a trader or an investor is free to make as many trading transactions as he would like within a single day. As leveraged trading enables opening bigger positions with limited deposit amount, trading CFD is possible even in cases of slight fluctuations of the asset value during one day.
Trading Stocks, Commodities, Indices and Currencies
A CFD (Contract for Difference) is a universal trading instrument, which has gained much popularity in the last years. With the help of CFDs, it has become possible to trade on the price movements of various financial instruments, without the need to possess them physically. Nowadays, CFDs allow to trade not only stocks but also major indices, currencies and commodities.
Trading on both Rising and Falling Markets
CFD is a flexible investment instrument. When you believe the market will rise you can make a profit by buying CFD which is known as going long. You can also speculate on falling prices by selling CFDs, known as going short. Holders of open buy positions on Stock CFD get a dividend adjustment equal to the announced dividend payment amount, if they have a long position open on the instrument at the beginning of trading session on the adjustment payment day (coincides with the ex-dividend date). In contrast, the dividend adjustment is deducted from customer's account in case of a short position.
Hedging the Investment Portfolio
If you believe that stocks you own are going to fall in price but still want to hold them, you can use the hedging strategy to protect your portfolio from risks by opening a short CFD position on your stocks portfolio. Your profits from going short in CFDs will reimburse the loss from the falling prices of the assets in your portfolio. You will carry lower transaction costs compared to hedging by selling the physical stocks in order to buy them back cheaper later.
You can study CFD trading more thoroughly and see CFD trading examples in the section How To Trade CFDs.
You can trade CFD for free, by downloading our CFD Trading Platform NetTradeX.