What is CFD Trading?

What is CFD Trading?
What are CFDs?

What is CFD
Trading and How
Does it Work?

A CFD or “Contract For Difference” is a derivative product which allows you to trade on the price movements of assets and indexes across local and international markets. While being complex, what they offer traders is quite simple. CFDs enable you to enter the market with only a fraction of the value of the asset you are buying, amplifying the potential for gains and losses, also known as leverage. Because a CFD focuses on price movements it is also possible to short a product, meaning the trader expects the price of an asset to decrease and profit from this movement. Lastly they enable the trader to take a position without having to take ownership of the underlying asset. This makes CFDs ideal for traders who want to gain a larger market exposure for a fraction of the full value while being able to enter and exit trades quickly.

CFDs are a unique derivative instrument where traders do not acquire the actual asset. Instead, they exchange the price difference of an underlying instrument such as stock indices or commodities. The amount paid is based on the difference between the opening and closing prices which are based on the price of the underlying asset. Another unique traits of CFD trading include the absence of an expiry date and the ability to trade in real-time using an online trading platform.

A major advantage of trading CFDs is that traders can benefit from price movements in both directions. Not only can you open long positions, you can also open positions to short the asset and capitalise from falling markets. Another attraction of CFD trading is the fact that they are a leveraged product. This allows investors to gain greater exposure to a market with less capital.

Those wanting to take part in forex and CFD trading need to become familiar with some key terms including bid price, brokerage, and margin. Once you understand the basics you will be able to access the biggest global financial markets and trade everything from forex (USD, GBP, EUR, CAD, AUD, and more). The video below explains CFD trading and how traders in Canada can use CFDs to trade global markets.

Video: CFD Trading Explained

How Do CFDs Work?

One of the key concepts of CFD trading is leverage. As a highly leveraged product, Contracts for Difference (CFDs) provide traders with the opportunity to profit from price movements without having to invest the total trade value of the trade. This concept is known as margin trading and dependent on the leverage level, allows traders to gain significant benefit from minor fluctuations in price. Only the difference in the prices (margin) is required to be deposited into your trading account for the trade to be placed.

Trade CFDs - What is
CFD Margin?

Margin is the amount required to open and maintain a leveraged position in CFD trading. To open and close positions you are first required to open a trading account. FP Market offers a variety of margin trading account types and the leverage level will depend on several factors. The main factor is the financial instrument being traded. For instance, major currency pairs such as the USD/GBP or USD/CAD offer higher levels of leverage than cryptocurrencies and shares.

Inexperienced Canadian traders should be aware that leveraged products are considered high risk and that retail investor accounts should always use risk management strategies. In addition, traders should keep a certain amount of capital in their trading account at all times. This serves as a buffer against losses and prevents the necessity of a broker to issue a margin call.

The margin percentage and leverage levels also depend on the regulatory body. The Investment Industry Regulatory Organization of Canada (IIROC) may have different regulations to that of ASIC in Australian or the Financial Conduct Authority (FCA) in the United Kingdom. Those who wish to trade with maximum leverage and capitalise on market volatility should explore whether they are eligible for a FP Market Pro Account.

Suppose that shares of the Royal Bank of Canada (RBC) are trading at $110 per share. You decide to buy 10,000 units of a contract at this price. Without leverage, the total value of this contract would cost you:

$110 x 10,000 = $110,000.

By using leverage, you can gain exposure to the same number of shares using significantly less capital. If the required margin is 5% of the total trade value, you would need only $5.50 per CFD unit in your trading account as margin.

Your total margin requirement will be
(0.05 x 110,000) = $5,500.

This is a tony fraction of the $130,000 that would be required to execute the trade without leverage. In this instance, you can gain the same amount of exposure with only 5% of the amount or 20 times exposure if wishing to use leverage trading for the entire amount ($110,000).

Going 'Long' or 'Short'

Not only is this a unique aspect of CFDs, it is also one of the main reasons for their rise in prominence in Canadian trading. Unlike most other financial instruments, CFD trading allows people to trade in rising and falling prices of an underlying asset. A predicted rise in value will instigate the purchase of an underlying asset, thus opening a long position. What makes CFDs stand out is the fact that traders can open a short position and 'sell' the asset. Short-selling is one of the unique aspects of CFD markets and among a long list of CFD trading strategies.

An Example of Leveraged CFD

Suppose you want to trade CFDs, where the underlying asset is the AUD/USD currency pair, also known as the “Aussie.” Let us suppose that the AUD/USD pair is trading at:

Bid/Ask Spread

Hedging is a popular risk management strategy that CFDs are often used for. Using CFDs and the concept of leverage, Canadian traders can hedge their portfolio against short-term market volatility within an existing position. Depending on the value of a trader's existing position and the asset they are hedging against, they may be able to hedge against a large position with only a fraction of its value.

You decide to buy AUD 20,000 worth of USD because you think that the AUD/USD price will rise in the future. Your account leverage is set to 100:1. This means that you need to deposit 1% of the total position value into your margin account.

Now, in the next hour, if the price moves to 0.6880/0.6882, you have a winning trade. You could close your position by selling at the current price of USD 0.6880.

In this case, the price moved in your favour. But, had the price declined instead, moving against your prediction, you could have made a loss. If that loss resulted in your account equity falling below your margin requirements, your broker may issue a margin call.

This small difference is known as “pip” or “percentage in point.” For Indices, 1 pip is equal to a price increment of 1.0 which is also called an Index point. In the forex market, like in the above example, it is used to denote the smallest price increment in the price of a currency. For assets like the AUD/USD, which include the US Dollar, a pip is represented up to the 4th decimal place. But, in case of pairs that include the Japanese Yen, like the AUD/JPY, the quote is usually up to 3 decimal places.

If the price
To You Could Gain or Lose
(for a long position)
Rises by +1% 22300.80/ 22312.80 USD 1044.00
Declines by -1% 21859.20/ 21871.20 USD -1164.00

How to Hedge Using CFDs?

Hedging is a popular risk management strategy that CFDs are often used for. Using CFDs and the concept of leverage, Canadian traders can hedge their portfolio against short-term market volatility within an existing position. Depending on the value of a trader's existing position and the asset they are hedging against, they may be able to hedge against a large position with only a fraction of its value.

For example, let's look at a CFD trader in Canada with an equity portfolio worth CAD 100,000 and composed of prominent shares on the Toronto Stock Exchange (TSX).

These are split up in 10 trenches of CAD 10,000 each. You could own CAD 10,000 worth of Royal Bank of Canada (RBC) shares and CAD 10,000 worth of Shopify (SHOP).

If you suspect that both these companies will suffer a short-term dip in share price, you could offset some of the potential losses by short-selling them using CFDs. Traders can protect against upcoming negative economic data such as earnings reports, general market volatility, or other a number of other reasons.

Instead of selling these shares in the open market, you would open two CFD short positions in RBC and Shopify. In many circumstances, 10% or less of the market exposure would be required to employ a hedging strategy. This equates to CAD 2,000.

Hedging using CFDs rather than selling the shares and buying them back later has several advantages.

  • Selling shares will likely attract capital gains which is taxable. Unless you no longer want the shares, this would be an unnecessary cost and would effectively minimise profits. In CFDs, you won’t need to pay stamp duty and trading costs will be limited to margin and spread.

  • If the value of the assets being shorted to decrease in price, the losses in your equity portfolio would be offset by your short CFD positions. Moreover, if profits of the short positions are taken and the value of the shares increase, the CFD short positions would provide an additional profit that would otherwise not have been obtained.

Hold Period

Forex and CFD trading is well known for day traders - persons who open and close a large amount of positions per day. If a CFD position remains open in your account after a market has closed, a holding cost may be incurred. The amount is dependent on the applicable holding rate and the direction of your position. The cost may subsequently be negative or positive. Those who trade CFDs should always factor in the holding cost.

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How Do You Start Trading CFDs?

Take a look at these
6 steps to start trading CFDs:

Step 1 |
Build Your Knowledge

Knowledge and experience are invaluable assets in CFD trading and it is essential to remember that successful traders never stop learning. You should consume as much content as you can to learn the fundamentals of CFDs and how to trade them. You can access educational materials on our Traders Hub Blog and learn from expert traders by watching live webinars.

Step 2 |
Open an FP Markets
Trading Account

Once you have grasped the basics, it is time to open an FP Markets CFD trading account. As a specialist CFD broker, we provide multiple trading platform options which have an array of risk management and trading tools. MetaTrader 4 and MetaTrader 5 are world renowned for their functionality. We also provide a Demo Account which is suitable for inexperienced traders as it allows them to practice trading with virtual currency.

The benefits of trading with a regulated CFD broker such as FP Markets include:

  • Tight spreads: Spreads on major currency pairs regularly start from as low as 0.0 pips as a result of our relationships with top-tier liquidity providers.

  • Fast Execution: Dedicated servers in the NY4 Centre are connected via fibre optics to our ECN network and liquidity providers. This ensures ultra-fast execution, low latency and minimal slippage.

  • Advanced Technology: Technology is at the forefront of what we do. Our trading platforms have been specifically designed to provide the ideal conditions for people that use automated trading strategies such as Expert Advisors (EAs) and Copy Trading systems.

  • Products: At FP Markets you can trade CFDs across Forex, Shares, Metals, Indices, Commodities & Cryptocurrencies. We offer 10,000+ tradable CFD products across global financial markets on desktop and mobile. Read more about What You Can Trade.

  • Customer Service: We pride ourselves on offering award-winning customer support. Our dedicated multilingual customer support team is available 24/7. Contact us using a variety of methods including Live Chat, Phone and Email.

Step 3 |
Create a Trading Strategy

Many inexperienced traders use copy trading systems but there is no replacement for developing your own trading plan. A comprehensive trading plan should consider the following key factors:

  • Asset class you wish to trade

  • Trading capital

  • Time commitment

  • Risk appetite

  • Trading experience

It should also outline any risk management strategies which will be used to promote longevity in CFD trading. Use our wide range of eBooks and dedicated webinar series to help develop a successful trading plan.

Step 4 |
Fundamental and Technical

Use market analysis to identify trading opportunities. The two most common methods are Fundamental Analysis

. Fundamental analysis focuses on the overall state of the economy by looking at a wide range of factors including geo-political events and economic data. It basically considers any information or news that may have an impact on global financial markets.

In contrast, technical analysis is the study of historical price movement to identify patterns. These patterns are then used to predict future movements in financial markets. Advanced CFD trading platforms such as MetaTrader 4 and MetaTrader 5 have a wide range of pre-installed indicators and charting tools that can be used by traders to conduct comprehensive market analysis in a time-efficient manner.

Step 5 |
Choose Your Trading Platform

MetaTrader 4 and MetaTrader 5 are market leading trading platforms. They provide a wide range of chart and trading tools that enhance a user's trading experience. Traders can track price fluctuations, follow the real-time news feed, and trade off charts.

Step 6 | Risk Management

The value of risk management in trading should never be underestimated and its presence is essential for every trade. Regardless of the market volatility, leverage level, tradable instrument, or size of the position, risk management should be used in every trade that is executed. Here are some tools that can be used to minimise risk and capitalise on positions:

Stop Loss Order: By placing a stop loss order, traders are able to direct the system to automatically close a position when the market reaches a certain price level. This can minimise losses and prevent traders from being exposed to a margin call.

Take Profit: Is possible when an open position has reached a profitable position and involves closing of that position at a specific level of profit. This protects your positions from unnecessary market risk and locks in a return that is aligned with your risk appetite and trading plan.

Trailing Stops: Are used to protect gains by adjusting your stop-loss in the event where the market continues to move in your favour. This order prevents your positions from getting closed too early.

For more in-depth fundamental and technical analysis plus trading education, please visit our Traders Hub blog.

Advantages of CFD Trading

Wide range of financial markets: FP Markets makes it possible for traders in Canada to access the biggest financial markets in the world including the NYSE, NASDAQ, and ASX. Our CFD offering consists of 10,000+ tradable instruments across forex, shares, stock indices, metals, commodities and cryptocurrencies. This includes currency pairs such at the USD/CAD and stocks in some of the world's biggest companies including Apple, Google and Tesla.

Trade in falling markets: You no longer have to be limited to taking long positions as CFD trading offers you the opportunity to go 'long' or 'short'. Typical financial markets only allow traders to open long positions which they would in turn close when a fall in prices is predicted. In contrast, CFD trading allows you to open short positions and benefit from declining price movements. This provides traders with additional trading opportunities and minimises trading costs.

Low Trading Costs: As you do not own the underlying asset, there are tax benefits associated with CFD trading. In addition, through the use of leverage, traders are able to make effective use of their capital by gaining greater exposure to a particular asset.

Leverage: Offers a cost-efficient way to invest as you only need to deposit a fraction of the trade's full value (margin) to open a position. Depending on the instrument, liquidity, regulations, and account type, traders can benefit significantly from minor price movements.

Effective hedging tool: Many investors use CFDs as a hedging tool. They can be used to hedge your portfolio against short-term market volatility within an existing position. Hedging is a strategy that CFD traders use rather than selling holdings in other instruments that may have associated tax implications. Potentially high levels of leverage are another reason why CFDs are a preferred choice when hedging.

Mirror trading the underlying market: CFDs are designed to mirror the trading environment, including prices, of their underlying market. Buying an RBC share CFD is the equivalent of purchasing a single RBC share that is traded on the Toronto Stock Exchange.

No fixed expiry: Unlike other derivatives such as options, ETFs, and futures, CFDs do not have an expiry date. CFDs can be used for short term trading or held onto as part of a long-term strategy.

CFD Trading - FAQ

In CFD trading there are three main terms with subsequent values that make up a trade. They are the 'Bid', 'Ask' and 'Spread'. 'Bid' (sell) is the sell price which is generally displayed on the left while the 'Ask' (buy) price is the higher of the two and the rate at which you can purchase the asset. The difference between these two prices is the 'spread' and is the cost of trading. The spread can be tight (small) or wide (large) depending on a number of factors including liquidity.

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