What Is CFD Trading? Contracts for Difference Explained

Interest in CFD (contracts for difference) trading has been growing. In January 2021, the search for “CFD trading” peaked significantly, reaching a score of 100 out of 100 in popularity on Google Trends. Traders saw potential in making a profit through CFDs. However, the risk involved isn’t to be taken lightly. So, what is CFD trading, how does it work, and how risky is it?

What is CFD Trading?

First, what is a contract for difference? A contract for difference is a financial contract between two parties to exchange an asset's price difference from the contract's opening and closing. These two parties are usually a trader and a betting company or CFD broker like XS.com.

Contract for difference (CFD) trading allows traders to bet on the price fluctuation of a financial instrument.

For example:

• Person A buys a crypto CFD for $10.
• The price in the market increases to $15, and Person A decides to close the contract and sell.
• Person A would make the difference between the open price ($10) and the close price ($15).
• Therefore, Person A would make a $5 ($15 - $10 = $5) profit.
• But, if the price drops to $5 and Person A sells, he has to pay the $5 difference.

Moreover, CFDs are a “derivative,” meaning traders don’t hold the underlying asset; they just speculate on its price movements.

Put simply, the price of a CFD will ‘mirror’ the underlying market's price. If Person A speculates that the price of an asset will increase, he will purchase multiple CFDs of that asset. If he is correct, he sells when the price goes up. If he isn’t, he’ll incur a loss.

How Does CFD Trading Work? Going Long vs Short

In the case of CFD trading, the trader bets on the price of an asset, for example, gold, instead of buying and selling the gold itself. Therefore, he makes a profit based on the speculation of price movement.

A CFD trader can go long, which means “to buy,” or can go short, which means “to sell.” If the trader assumes the price of an item will increase, he will go long. Whereas if he thinks its price will decrease, he will go short.

Case A: Going Long

• The asset price is at $10.
• Person A assumes it will increase so he buys it.
• Asset price increases till $15, he closes the contract and profit.
• Therefore, by going long, Person A would’ve made a profit of $5 per the asset’s CFD.

Case B: Going Short

• Asset price is $10.
• Person A assumes it will drop below $10 so employ a CFD trade by selling the asset’s CFD at $10.
• Asset price drops till $5, Person A closes the trade.
• Person A then buys back the CFD at $5.
• Therefore, by going short, Person A would’ve made a profit of $5 per the asset’s CFD.

It’s important to note that there are NO:

• Limitation on the entry or exit price of a CFD
• Time limit on when the exchange should take place
• Restriction on buying first or selling first

CFD trading is usually done through an online platform or CFD brokers. These brokers offer access to various tradable assets and account features (e.g., different leverages, margins, etc.).

For instance, we offer multiple tradable instruments at XS, like shares, indices, metals, energy, crypto, currencies, commodities, and futures. We also offer multilingual customer support in multiple languages.

Contracts for Difference: Leverage, Margin, and Spread

To better understand CFD trading, you must understand the meaning of the following trading terms: leverage, margin, and spread.

Leverage

Leverage refers to the ability to manage a more prominent position in the market with less capital. It is like borrowing funds from a CFD broker, although you are not physically borrowing any money.

For example, some brokers offer a 1:10 leverage. This means that for each deposited $1,000 in your account, you can buy up to $100,000 (deposited amount * 10). We offer a dynamic leverage up to 1:2000 across various account types and asset classes.

Thus, you can increase your exposure to an underlying asset that you wouldn't usually be able to afford. However, this also implies amplified risk. It’s the perfect scenario to win big while spending small. But it also is the worst scenario to lose big when spending small.

When using leverage, you are responsible for the asset's actual value. So, if you spend $100,000 on a CFD for a particular asset using the leverage, then it drops $50,000 in price; you have to pay the $50,000 even if you only deposit $1,000.

Margin

When trading with leverage, a trader must always keep in his account a specified percentage of the total position as a “margin.” Basically, a CFD margin is the amount of funds you need to have available to enter any trade physically.

This margin serves as a contingency fund to offset possible losses. A margin call, which requires the trader to deposit more money to keep the position open, may be issued if losses bring the account balance below the necessary margin.

Spread

The "spread" in CFD trading is the difference between the price at which a financial asset is bought (ask) and sold (bid). It serves as the broker's payment for facilitating the transaction and indicates a fee the broker charges to execute the trade. This is essentially the cost of CFD trading and how brokers make money.

There are two types of spreads: variable and fixed. Variable spreads can change depending on the broker's fee schedule, market volatility, and liquidity. Fixed spreads are constant in a typical market.

The spread’s size impacts a trader's profitability:

• narrower spreads, or more minor differences, are preferable since they lower trading costs
• wider spreads, or more significant differences, raise costs

When initiating a trade, traders must consider the spread because they have to close a position wider than the spread to start making money.

Moreover, traders must understand the effect of spreads, especially when assessing the overall cost-effectiveness of their trades and choosing brokers who provide competitive and transparent spread pricing.

Benefits of CFD Trading

Trading CFDs (Contract for Difference) has several benefits for traders.

• Leverage: Offers you the opportunity to trade more significant positions with less capital, which could increase your profits.
• Diverse Market Access: Provides multiple market opportunities from a single platform by enabling CFD trading in various financial assets, including equities, indices, commodities, currencies, and cryptocurrencies.
• No Ownership of Underlying Asset: By speculating on price changes without holding the underlying asset, you can avoid the expenses and complications of physical ownership.

How Risky Is CFD Trading?

Trading CFDs (Contract for Difference) is risky because of leverage and market volatility. Leverage increases the potential for both gains and losses. For example, a trader holding a leveraged position may lose more than 1% of their initial investment in the event of an adverse 1% market change.

Furthermore, abrupt and large price swings brought on by market volatility might result in quick gains or losses. CFD trading is risky and demands careful thought and risk management. Traders must manage risk carefully and be ready to lose all their invested capital, or even more, if they employ large leverage.

Conclusion

In conclusion, CFD trading offers traders opportunities to profit based on speculation of the price movement of certain assets without holding the underlying asset. It is facilitated through CFD brokers, like ourselves, and is a relatively easy way for traders to make money. However, it is risky, and traders, especially newcomers, must be careful when trading contracts for differences. Moreover, you must know how to choose the best CFD broker to avoid getting scammed. The space is plagued with fraudulent websites, so thoroughly research before depositing your funds anywhere.