A Contract for Difference (CFD) is an agreement between two parties to exchange the difference in the value of an underlying asset, such as a stock or commodity, from the time the contract is opened until it is closed. Traders trade CFDs on margin, which allows them to gain exposure to the market with a smaller initial investment than would be required to buy the underlying asset outright.
The anatomy of a CFD contract includes several key components that allow traders to speculate on asset prices as the market moves. In this article, we will explore what each Contract for Difference contains, and how you can make more informed decisions when trading CFDs regardless of your skill level. If you are keen to level up your trading skills, read on.
Elements in a Contract for Difference
Understanding the anatomy of a CFD contract is essential for traders who wish to trade these instruments successfully. By understanding the key components of a CFD contract, traders can make informed decisions about their trades and manage their risk effectively.
First is the underlying asset, which can be almost anything that has a tradable price, such as a stock, commodity, index, or currency. You should choose an asset you are most comfortable with in terms of knowing how the market works and what influences the price of the instrument. This will invariably include conducting sufficient market research before you purchase a contract.
The second component is the position direction you as the contract holder will take. There are two positions you can take: long or short. If you go long, you are essentially speculating on the underlying asset price increasing, while if you go short, you are essentially speculating on the underlying asset price decreasing.
The third component is the contract size, which determines the value of each unit of the underlying asset. For example, a CFD contract for one ounce of gold would have a contract size of 1 ounce. If you would like to speculate on six ounces of gold, you will need to purchase six contracts.
The fourth component is the contract price. This is the price at which the contract is traded. The underlying asset market price has a big influence on the contract price, as the latter is often set equal to the former. As the market moves, the contract price also moves.
When a trader closes their CFD trade, they calculate their profit or loss based on the difference between the contract price at the trade’s opening and the contract price at the trade’s closing. Other factors contribute to the contract price, such as the supply and demand for the underlying asset, economic data releases, and geopolitical events.
CFDs’ settlement styles can vary, but the most common method is cash settlement. This is when the contract seller and holder settle the difference between the opening and closing prices of the contract in cash. Thus, there is no physical delivery of the underlying asset, and the trader receives the profit or loss in the base currency of their account.
Some CFDs do have physical settlement, where the contract seller or holder delivers the underlying asset upon expiry of the contract. However, this is less common due to logistics and convenience.
The margin requirement is the amount of funds that must be deposited for the trader to open their position. This is usually a percentage of the value of the underlying asset, and it is designed to ensure that traders have enough funds to cover any potential losses.
The seventh component is the spread, which is the difference between the buy and sell prices of the contract for difference. The spread represents the cost of trading, and it is how CFD providers make their money.
The eighth component is the funding charge, which is a daily fee that is charged for holding a position overnight. The funding charge is based on the notional value of the position and the prevailing interest rates. If a trader is long on a CFD, they will pay the funding charge. If they are short, they will receive it.
Stop-loss and take-profit orders
Finally, there are also risk management tools built into contracts. The two most common ones are stop-loss and take-profit orders.
A stop-loss order is an instruction to close a position if the price moves against the trader by a certain amount. Traders use stop-loss orders to limit potential losses, should markets move against them. On the other hand, a take-profit order is an instruction to close out a position if the price moves in the direction the trader was expecting, by a certain amount.
Do CFDs have fixed expiry dates?
Traders who are familiar with derivative trading – such as options and futures trading – may wonder if CFD trading follows a similar vein and has a fixed expiry date. In fact, CFDs do not have a fixed expiry date, unlike options and futures contracts. This means that traders can hold their positions for as long as they want, provided that they have sufficient margin to cover any potential losses.
The absence of an expiry date in CFDs is one of the key features that makes them attractive to traders of all types. It allows them to maintain their positions for an extended period and potentially benefit from a longer-term price trend.
However, traders should keep in mind that holding a position for too long may also increase their exposure to market volatility and potential losses. Therefore, it is essential to have a sound risk management strategy in place when trading CFDs.
How to start trading CFDs
To start trading CFDs, you can follow these general steps:
Learn the basics
Before starting to trade CFDs, it’s essential to learn the basics of trading and understand the potential risks involved. You should research different strategies, read educational materials, and seek advice from experienced traders.
Choose a reputable broker
You will then need to open an account with a reputable broker that offers CFD trading. You should research different brokers and choose one that suits your needs, considering factors like trading fees, regulation, and available markets.
Fund your account
After choosing a broker, you will need to fund your trading account. Most brokers offer different funding methods, such as bank transfer, credit cards, or electronic wallets.
Select the market
Once you have funded your account, you can choose the CFD market you want to trade. You can trade CFDs on a wide range of financial instruments, such as stocks, indices, currencies, and commodities.
Determine your position
You will then need to determine the position you will take, which is to decide whether to go long (buy) or short (sell) on the chosen market. Going long means buying the CFD in the hope that its price will increase, while going short means selling the CFD in the hope that its price will decrease.
Place the trade
You can then place the CFD trade with your broker’s trading platform. You should set your stop-loss and take-profit levels, which help limit your potential losses and lock in your profits.
Monitor the trade
Once your CFD trade is open, you should monitor it regularly and adjust your positions accordingly based on market conditions.
The bottom line
Understanding the anatomy of a CFD contract is essential for traders who wish to trade these instruments successfully. By understanding the key components of a CFD contract, traders can make informed decisions about their trades and manage their risk effectively. Keep in mind that CFD trading involves a high level of risk, and you can lose more than your initial investment. Therefore, it’s crucial to manage your risk effectively, set up a trading plan, and stick to it.