Trading Course for Beginners: Course 1


Lesson 1: Introduction to CFDs

Reading Time: 8 Minutes

A contract for difference, or ‘CFD’, is an over-the-counter leveraged trading product, functioning through what’s known as a derivative—an instrument essentially mirroring price movement of an underlying market, or underlying asset. CFD products offer market participants the ability to trade a broad range of asset classes, including foreign exchange (Forex), individual stocks (equities), indices, commodities and cryptocurrencies.

Formed through ‘contracts’ between a buyer and seller, the CFD market allows traders and investors to speculate on the future course of a market’s price movements without taking ownership of the underlying asset. By way of an example, a trader who believes the price of gold will advance can trade a commodity CFD based on the underlying price of gold (ticker: XAU/USD) without purchasing the underlying commodity. Similarly, an investor wishing to invest in Apple (ticker: AAPL) can purchase (or sell) a share CFD based on the underlying stock price (share price) of Apple.

CFD hedging also remains a popular cost-effective strategy to offset potential losses.

CFD Trading Terms

• Going Long

Based on analysis, if a trader believes the price of a financial instrument will rise, a CFD trader can execute a ‘buy position’. In trading parlance, this refers to a ‘long position’ in which the trader gains in the event of a rise in price.

• Going Short

If a trader anticipates the price of a market may fall, selling the respective CFD instrument is an option, a short position which can result in a gain following a sell-off.

• Opening and Closing Price

The opening price is the ‘execution price’ filled by a CFD provider. Traders often refer to this value as an ‘entry price’. The closing price is a ‘liquidation price’, a price value in which a trader elects to close an active CFD position.

CFDs work by exchanging the difference in value between the opening and closing price of a CFD position.

• Protective Stop-Loss Level

For many CFD traders, the use of s protective stop-loss order is essential risk management, in place to reduce further loss beyond a pre-determined risk tolerance.

• Leverage and Margin

Leverage and margin are related concepts.

Leverage represents the capacity to increase exposure to amounts larger than available equity in a trading account. Greater returns are, therefore, possible when employing leverage, though it’s important to note that increased risk of larger losses are also present. Each CFD broker has a maximum allowable leverage: 50:1, 100:1 and 500:1, for example. A 100 USD account using 100:1 leverage means for every 1 USD in a trading account, the trader effectively has access to 100 USD.

Traders and investors employ margin to generate leverage. Higher leverage equals lower initial margin requirement and lower leverage equals higher initial margin requirement. In the case of Forex, the broker permits clients to use leverage through margin, or ‘initial margin’ expressed as a percentage (a portion of your account held by the broker to ensure the trader has the means to cover any potential losses). Think of initial margin as a ‘good-faith deposit’ to trade, which, assuming risk is controlled by the trader is returned once the trade is settled.

A common misconception about trading with leverage is that leverage is a loan in CFDs. This is not true. CFDs are based on agreements (contracts between two parties). In FX, we do not trade the underlying market. We trade derivatives in the form of contracts based on the underlying market. As an example, if we trade 1 standard lot on EUR/USD at $1.13528 (100,000 units of the base currency), we are, with a USD trading account, trading at 10 USD per pip (if we trade 10,000 units, pip value would be 1 USD each pip). With leverage of 100:1, this requires you deposit 1 percent as initial margin: 1,135.28 USD (If the account is denominated in EUR, initial margin would be 1,000 EUR). Trading on margin ‘grants’ traders access to a larger position size: increased exposure.

• Over-the-Counter Market

Two primary avenues exist to trade in the financial markets: the over-the-counter market (OTC) and exchange-based trading.

OTC operates between two parties (as in the CFD market), built through decentralised dealer networks. Exchange-based trading is considered more structured, a forum that limits counterparty risk.

Advantages of CFD Trading

• CFDs are leveraged products, meaning you’re only required to deposit a small amount of the notional position (initial margin) to trade.

• The ability to trade both rising and falling markets.

• CFD positions have no fixed expiration date and cash settled (no physical delivery).

• Since you don't own the underlying asset when trading CFDs, there is no stamp duty to pay in the United Kingdom. Nevertheless, market participants are subject to capital gains tax (CGT). Tax treatment, of course, will depend on your individual circumstances.

• Market access. CFDs opens the door to global markets from one trading platform.

• Cost efficient.

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