The ChoosaBroker Trading Academy
8.2. Basic Concepts of CFD Trading
CFD stands for Contracts for Difference and is a financial derivative instrument that speculators use, mainly for short term trading. Trading a CFD means that you enter into a contract to exchange the difference in an underlying asset’s price from the time you open the position to when it is closed.
Let us look at five important concepts of CFD trading to gain a better understanding of how the market operates.
01. Spreads and Commission
CFDs are quoted in two prices – the buy price and the sell price. The buy price, also called the offer price, is the rate at which you can initiate a long CFD. The sell price, or bid price, is the price you have to pay to open a short CFD. For most underlying assets, the sell price for a CFD will be lower than the current market price, while buy price will be higher. The difference between the offer price and the bid price is termed as the spread, and is the primary source of income for a CFD broker. However, in case of stock CFDs, the buy price and the sell price always mirror the rate in the underlying market and the charge for initiating a stock CFD position is based on commission.
02. Trade Size
CFD contracts are standardised and are traded in fixed lots. The size of any given contract will vary depending on the asset being traded. Silver, for example, is available on leading commodity exchanges in lots of 5000 troy ounces. Its corresponding CFD contract also has a market value of 5000 troy ounces. For stock CFDs, a single contract usually represents one share of the company you want to trade. Hence, to enter long in a CFD trade that is equivalent to buying 500 shares of HSBC, you simply purchase 500 HSBC CFD contracts.
03. Leverage
Trading CFDs is similar to trading stocks or commodities, except you need a much smaller initial capital to control the whole position. For example, if you wanted to purchase GBP 100,000 worth of CFD stocks on the U.K. market, you would need somewhere around 10% as upfront margin, or GBP 10,000. The remaining 90% is lent by the CFD broker. If the share price were to rise 10% to GBP 110,000, you would be sitting on an open profit of GBP 10,000. When we consider the Return on Investment, you have made a gain of $10,000 with an initial investment of GBP 10,000. That equates to a whopping 100% return!
04. Order Types
A CFD trade order instructs a broker to enter or exit a position. Let us look at the three major types of CFD orders –
- Market Order – A market order buys or sells an underlying asset at the next available price. It results in prompt trade entry, but should be avoided in highly volatile markets.
- Limit Order – A limit order is an order to buy or sell an asset at or below a designated price. Limit orders are the preferred choice of professional traders, who avoid the pitfalls of chasing a market.
- Stop Order – A stop order is used to enter a position in a security when it hits a certain price threshold. Stop orders are typically used to protect unrealized profit or prevent further loss in the event of price moving against you.
05. Duration of Trade
Unlike spread bets and options, CFD trades don’t have a fixed expiry time. A position is closed by opening a trade in the opposite direction. A long trade on 100 contracts of gold, for instance, will have to be closed by selling 100 contracts of gold. As has been mentioned above, CFD trading is primarily carried out over the short-term. In case you want to keep a CFD position open after the close of a trading session, your broker will charge an overnight funding fee, which reflects his cost of lending you the capital to open a leveraged trade.
Understanding Pip and Point Movement in CFDs
In CFD trading, a “pip” is equal the minimum amount by which an underlying asset should change in price for a single contract-for-difference to change in value. Typically expressed as a decimal, the exact value of a “pip” for any underlying instrument can be found in the “Contract Specifications” section of your trading platform.
For example, if you buy a CFD on stock XYZ at $1.00, a price movement to $1.01 or $0.99 would represent 1 pip. For CFD Forex pairs, one pip is equal to 0.0001, except for when considering Japanese Yen, in which case it is 0.01. Thus, to put it simply, 1 pip = 1 point and is the minimum amount by which the CFD contract needs to change in value to register a change in your unrealized profit or loss.
How to Open a CFD Position
When trading CFDs you are taking a directional view on the underlying asset on which the CFD is based. If you have a bullish outlook and expect the underlying asset to rise in price, you would buy (go long) the CFD. Contrarily, if you believe the underlying asset’s price is overbought and is likely to fall, you would sell (go short) the CFD.
When opening a CFD position, there are a couple of important things to keep in mind:
01. Buy and Sell Prices
Your CFD provider will invariably quote two prices for any underlying asset: the buy price (bid rate), and the sell price (ask or offer rate).
The buy price will always be higher than the current price of the underlying instrument, while the sell price will always be lower. The difference between the two is referred to as the bid-ask spread, or more commonly, the spread.
02. Number of Contracts
Let us now look at a simple step-by-step guide through the complete CFD trade-making process:
STEP 1: IDENTIFYING THE TRADE OPPORTUNITY
Let us now assume that trader James, after due analysis, forecasts the share price of Plus 500 to rise. Plus500 has a minimum lot size of 1,000 shares. The resulting trade is to Buy Plus500 Share CFDs
| Contract | CFD Bid Price | CFD Ask Price |
|---|---|---|
|
Plus500 |
$2.20 |
$2.25
|
STEP 2: DECIDING ON TRADE SIZE
James buys 10 lots of Amstore CFDs or 10,000 underlying shares @ $2.25 per share.
Trade Value: $2.25 X 10,000 = $22,500
Initial Margin (10%): $2,250
Traders should keep in mind that since CFDs are leveraged products, they only need to put down a small initial margin to gain full exposure to the contract value. This means that the potential returns and losses both get magnified. As a matter of practice, traders should never avail of the maximum leverage on offer. A prudent trader always sizes his or her trades to suit their own risk parameters and incorporates effective risk management tools like stop losses and take profit levels to diminish the likelihood of suffering a big loss.
STEP 3: PLACING CFD LIMIT AND STOP ORDERS
To help protect against potential losses, you might choose to add a stop-loss and limit level. Stops are intended to automatically close out your position in the event of the underlying market moving against you by a certain specified amount. Limits, meanwhile, do just the opposite. They close your position when the market moves by a certain distance in your favour. Both of these are handy risk management tool, especially in volatile markets. Once all of these specifications have been finalized, the trade can either be executed via the CFD trading platform or by calling the dealing desk.
Buy Price: $2.25
Trade Size: 10 lots of Amstore Inc CFDs
Stop Loss: $2.00
Target Limit: $2.75
Risk-to-Reward: 1:2
STEP 4: MONITORING AND EXITING FROM A CFD POSITION
Once you have entered in to a position, your profit or loss will fluctuate in line with the underlying asset’s market price. Monitor all of your open positions in real time on the CFD platform, so that in the event of any new bullish or bearish catalysts manifesting themselves, you can immediately update your stop and limit levels.
When you think you are ready to book your profit or cut your losses, you can do so manually by placing the opposite of your entry order. So if you initiated your position by placing a buy order, you would close by selling the same number of contracts at the bid rate – and vice versa.
Sell Price: $2.50
Trade Size: 10 lots of Amstore Inc CFDs
Total Profit: $0.25 X 10,000 = $2,500
Important CFD Trading Tips
- Define Your Trading Goals and Adopt a Compatible Trading Style.
- Select a Methodology and Calculate its Success Rate.
- Be Consistent in the Application of Your Strategy.
- Choose Your Entry and Exit Time-frames Carefully.
- Keep Your Losses Small and Let Your Profits Run.
Final Thoughts
CFDs offer a number of lucrative advantages to traders. Profitable opportunities exist for those willing to invest the time to gather the knowledge and the skill to make the right bets. Success in CFD trading is no different from success in any other field. Dedication and hard-work remain the keys to unlocking your profit potential. For more information on the best CFD brokers or if you are looking for the best brokers for beginners or need more information on the options for top day trading brokers.
Ready to trade? Check out these top CFD brokers or these great UK Forex brokers!