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What are CFDs?

September 12, 2019
by Nick Alexander, Market Analyst

Article Recap

A CFD allows investors to trade price movements of financial instruments instead of the physical asset.

What are CFDs? 

CFD stands for Contract for Difference. It is essentially a contract that is made between two parties to trade a financial derivative. A derivative is the value of the financial asset without you having to buy or sell the underlying asset. When you enter the contract between yourself and the CFD provider, both parties will agree to pay the difference in price movements of the financial asset, from when the position has been opened to when the trade’s been closed. A CFD allows traders to speculate on price movements without committing to long-term investments. With CFD trading, you will also be able to access various financial instruments such as Indices or Commodities that may not usually be available in your local market or timezone. 

An example of trading CFDs

If a trader wants to buy and hold the price of the ASX200 (benchmark index in Australia composed of the 200 largest companies in the country) the index increases in value and then the trader closes the position. The CFD provider will then pay the trader the difference in value from the contract’s opening price to the closing price. However, if the index falls in value the trader could risk losing money and possibly owe the CFD provider more than their initial deposit. 

There are numerous benefits of CFD trading, one being that you are able to trade on margin, where you can go long or short depending on if you think the price will rise or fall. However trading on margin is high risk and as well as a chance of making profits, losses can also exceed the initial deposit placed. You can trade CFDs via the award-winning MT4 and MT5 platforms with Eightcap, our platform ensures that you can trade anywhere you are across multiple devices. 

What is trading on margin?

CFDs is a leveraged product and to trade on margin you need to deposit a small percentage of the full value of the trade you wish to open. When you trade on margin, you will have the opportunity to magnify any profits made. However, this also means that any losses you make will also be magnified, so you should be taking measures to prevent and minimise trading risk. This is known as risk management, find out more here.

You won’t be able to trade CFDs through an exchange, instead, you will have to open a trading account with a CFD provider. Eightcap is a regulated broker, providing CFDs on a range of financial products. Once you open a trading account, you will be able to access your MT4 or MT5 trading platform. This software will enable you to open positions on the financial markets using leverage. 

What does it mean to go ‘Long’ or ‘Short’?

‘Long’ and ‘short’ refers to the positions you are taking when opening your trade. When trading CFDs you are able to speculate on which way the price will move. If you believe the price of the asset will go up, this is called going ‘long’, if you think that the price will go down then this is known as going ‘short’. 

For example, if you think the ASX200 is going to fall in price, you could open a position to sell. You will still be able to exchange the difference in price from when you open the position to when you close it, however, you will gain a profit if the price of the index falls or a loss if the index price rises. 

Are there any costs associated with trading CFDs? 

Like most financial instruments there is a small cost attached to trading CFDs: 

Spread – Traders must pay a spread when buying or selling a financial asset. The spread is the difference between the buy and sell price of an asset and is normally represented as pips. Traditional brokerage fees are replaced by the spread, and while the spread may be small it decreases the profit on a winning trade. The trader will pay the spread once the position has been closed. 

Swap – A swap rate is also known as the rollover rate and refers to the fee or interest rate that is charged on positions that are held overnight in FX trading. The swap rate isn’t a set rate and is determined by the difference in the interest rate between two currencies used to trade. 

Advantages of trading CFDs 

CFDs are becoming increasingly popular with retail traders because of its advantages over trading stocks. 

Margin and Leverage – This is what makes CFDs most attractive to traders, the ability to trade large positions by placing a small deposit, making it affordable. However, it is important to note that there is high risk when trading on margin as losses can exceed deposits. 

Access to global markets –  CFDs also give retail investors access to financial instruments they wouldn’t usually be able to trade. For example, index CFDs allow traders to speculate on the movements of the FTSE100 or the CAC, without having to buy individual stocks in the index. Just like FX trading, CFDs can also be traded 24 hours a day, 5 days a week and across major interbank sessions. With long trading hours, CFDs are more accessible than stock trading which can only take place during exchange opening times. 

Hedging and Scalping – CFDs can also be used to hedge and scalp trades. These are two different trading techniques used to offset and reduce risk. Direct hedging involves opening two positions on the same financial instrument, (buy and sell). Scalping, on the other hand, relates to buying and selling very small positions 

What are the risks when trading CFDs?

Even though there are many advantages to trading CFDs, there are also certain risks you should be aware of. 

Magnified Losses

Low margins and high leverage can magnify gains but at the same time losses can also be magnified. If the financial instrument you are trading moves against 

Fast-moving markets

Fast-moving markets come with high liquidity. When there is an economic release or a political comment broadcasted it can drastically move the market. If traders aren’t monitoring their positions closely, they can be at a loss. 

If you are ready to start trading the financial markets then you can easily open a trading account with Eightcap in three easy steps. We also have a free demo account so you can practise going long or short

All times are AEDT.