Contracts for Differences, or CFDs, are the new hip in online trading. Falling under the “Margin Trading” category, this type of investment allows people like you and me to trade assets at only a small fraction of the cost (sometimes as low as just 2%). You can trade Forex, Indices, Commodities, Stocks, and even Treasuries.
Most people unfamiliar with the concept, think of it as some form of online gambling. In a way, they’re right, because you do place a position to be higher or lower than when you opened the contract. Except for the fact that in online trading, you have several tools at your disposal to ensure you make smart investments, instead of just blindly placing your bets without any knowledge whatsoever.
CFDs Key Concepts.
Let’s begin with a quick reminder of what a CFD really is. CFDs are a form of derivative trading in which you are presented with a potential profit by speculating on the rising or falling prices of any given asset at the moment of closing the contract, compared to when you opened it.
There is a difference in value between the buying and the selling prices, and this is called the “spread”. When you enter or open a contract, you do it at the buying price. And when you exit or close it, you do it at the selling price. Simply put, the narrower the spread is with your particular CFD provider, the less price movement you need in order to make a profit (or loss).
A position value is the total value of the asset you are placing your position in. A position margin is how much you are actually investing in it. Usually a small number, starting as low as 2% of the total position value, also known as a margin rate.
Going long on a position means you think the selling price will close higher than the price you bought it at; a rising market. Going short on a position means you think the selling price will close lower than the price you bought it at; a falling market.
Whenever you are trading shares, commissions are also charged. You are charged a commission both when you open a position, as well as when you want to close it. Usually, there is a minimum value charged, and if surpassed, then it responds to a small percentage of your total position value. Commission fees also vary depending on each market.
CFD Trading – Example.
Now that we’ve got the basics covered, let’s do some math and apply our knowledge to the market. Suppose you think the market will rise so you want to open a long position trading shares from company XYZ which is trading at 0.98/1 and decide to open a position at 10.000 shares, a unitary value of $1, a 0.1% commission charged, and a margin rate of 2%.
Case Study 1 – Winning Scenario.
You were right and the market did rise, so you close the position at 1.1/1.12, which gives us the following profits:
Differential Value: $0.1 x 10.000 units = $1.000
Commissions Charged: (10.000 units x $1 x 0.1%) + (10.000 units x $1.1 x 0.1%) = $21
Total Profit: $1.000 – $21 = $979
Case Study 2 – Losing Scenario.
You were wrong and the market fell, so you close the position at 0.93/0.95, which gives us the following losses:
Differential Value: -$0.07 x 10.000 units = -$700
Commissions Charged: (10.000 units x $1 x 0.1%) + (10.000 units x $0.93 x 0.1%) = $19.30
Total Loss: – $700 – $19.30 = -$719.30
As you can see, the profit potential is maximized with CFDs, and so are the potential losses. However this shouldn’t hold you back, but instead, what we recommend is that if interested in online trading, then you should seek a trustworthy CFD provider with a great background history and optimal investor support and learning center. CMC Markets can definitely suit you in all those aspects to guarantee you have a nice flowing experience in online trading.