The Forex currency market is quite naturally associated with trading currency pairs. However, decentralization of the market gives freedom in terms of choosing trading assets and, accordingly, earning opportunities. This is a significant advantage that allows you to make money on the difference in prices of instruments on the largest exchange platforms, while greatly reducing the minimum threshold for entering the “big game”. Read more in our article today.
Definition of a CFD Contract
CDF is
an agreement between two parties - the seller and the buyer - to transfer the difference between the current value of an asset (at the time the contract is concluded) and its future value (at the time the contract is closed).
CFD is a derivative financial instrument
, which is actively used in trading on financial markets.
In CFD trading, the seller is not required to own the actual asset, and the buyer does not have the right to demand delivery. Therefore, CFD contracts are mainly used for speculative purposes
, that is, with the aim of making a profit on the price difference.
✔️ Synonyms
: Contract for difference.
✔️ Etymology
: The English abbreviation CFD means “Contract For Difference”, which is translated into Russian as “Contract for Difference”.
FAQ
What does CFD mean?
CFD stands for Contract for Difference.
Spread betting vs CFD - what's the difference?
On the one hand, CFD trading and spread betting are similar in that you can trade financial instruments without owning the underlying asset. However, calculating profits and losses is where CFDs and spread betting differ.
What is the minimum deposit required with a CFD broker?
This will depend on the CFD broker in question. Most brokers operating in the UK ask for at least £100, although others may ask for more.
Who regulates CFD brokers in the UK?
The Financial Conduct Authority is responsible for authorizing and regulating CFD brokers in the UK. When it comes to leverage limits, UK CFD brokers must comply with the limits set by ESMA.
What can I trade with a CFD broker?
CFD brokers typically provide thousands of tradable instruments. Whether you want to trade stocks and shares, ETFs, indices, interest rates, cryptocurrencies or energies, you'll surely find CFDs.
What payment methods do CFD brokers accept?
Supported payment methods vary from broker to broker. This could be a bank transfer, debit/credit card or e-wallet.
Basic vocabulary for CFD trading
➡️ Opening a CFD contract
– this is the opening of a transaction to buy or sell a certain asset of a specified volume.
➡️ Closing a CFD contract
– this is the closing of a previously open transaction to buy or sell a certain asset of a specified volume.
➡️Position
(order, transaction) is a transaction to buy or sell a selected asset of a specified volume.
➡️ Volume (lot) of the CFD contract
is the number of units of the selected asset that the trader plans to trade using the CFD contract. For convenience, the volume is expressed in lots. In many trading terminals, the minimum size to open a position is 0.01 lot.
➡️ Forex market (Forex, FX)
– a foreign exchange market that does not require the use of CFD contracts, but where you can make transactions to buy or sell various currencies. In finance, CFD contracts and Forex (FX) trading are, by definition, different trading instruments.
When trading a currency pair, a trader always buys one currency and sells the other. Therefore, he does not need to use additional derivatives to enter into buy and sell trades.
TRADE CFDs and Forex
➡️ Trading CFDs on the stock exchange
- What is this? This is the execution of trading purchase and sale operations with stock market instruments.
➡️ Opening a buy position
(“long position” or “BUY”) means opening a transaction in anticipation of an increase in the quotes of the selected asset. For example, if a trader predicts that the price of the Bouygues stock will increase from 35.00 to 40.00 euros, then he can open a position to buy a CFD on this stock. If quotes rise, the trader can make a profit on this transaction.
➡️ Opening a sell position
(“short position” or “SELL”) means opening a transaction in anticipation of a fall in the quotes of the selected asset. For example, if a trader predicts that the Bouygues share price will fall from 35.00 to 30.00 euros, then he can open a sell position. If quotes go down, the trader can make a profit on this transaction.
➡️ Modification of an open position
– this is a change in the stop loss and take profit levels of an open position. These levels are set in the trading terminal to automatically close an open position when the price reaches certain values with a loss or profit for the trader.
➡️ Closing an open position
involves fixing profit or loss on an open position. Closing can be done automatically or manually.
➡️ Margin Call
- This is a broker's request to replenish the account, caused by a significant losing position of the trader. In this case, if the trader does not take any action and his loss continues to grow, the broker himself closes the trader’s open positions (otherwise the broker may incur losses).
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Risk management strategies when working with CFDs
CFDs are complex instruments and trading them involves a high degree of risk. The value of an asset can rise and fall, so you may suffer losses if the market moves against your expectations. Risk management is one of the most important practices for successful trading.
Once you have set up your account and developed a trading plan, it is important to decide how much risk you are willing to take and formulate an appropriate trading risk management strategy. If you are risk averse, you will tend to choose strategies with a low risk-to-reward (RR).
For example, if you are looking for an instrument that exhibits slow but steady growth, higher volatility asset classes should make up a proportionately small portion of your portfolio. It is highly recommended to diversify across all asset classes to increase the likelihood of taking advantage of all successful trading opportunities, as well as reduce risk.
Stop loss and take profit
In order to be able to avoid sitting at the monitor all the time and constantly monitoring the market, it is necessary to use limit orders that allow you to automatically close positions at a given profit level. Take profit orders reduce the likelihood that you will miss a favorable price for an asset and not have time to exit at a good price.
Likewise, you can place stop loss orders to reduce your risk and thereby limit your potential losses. A stop loss is a threshold price at which a position will be automatically closed if the asset falls below the level you have defined as the maximum allowable fall.
Stop orders are the most important element in building your own risk management system, so we strongly recommend that you do not neglect them.
Protection against negative balance and margin calls
If a trade you open does not meet expectations, Capital.com provides deposit protection against losses exceeding the deposit amount. In order to keep positions open, a trader must meet margin requirements - this is the minimum amount of funds required to cover the credit risks arising from trading.
The amount held in the account as margin guarantees the borrowed funds. If margin requirements are exceeded, Capital.com sends clients a so-called “margin call” - this is a requirement, the essence of which is the need to deposit additional funds if you want to leave unprofitable positions open, or close some positions to reduce risk.
If no action is taken, positions will be closed automatically.
With negative balance protection, you can rest assured that your account balance will never drop below zero. There are situations when the market suddenly moves strongly against you, in which case the Capital.com platform has automatic protection that will close the corresponding positions.
But you shouldn’t relax and ignore the principles of risk management, especially when it comes to CFDs on highly volatile instruments such as cryptocurrencies. It is important to carefully consider your understanding of CFDs and assess whether you can afford the risks associated with CFD trading.
Hedging
Hedging is an essential risk management strategy used by experienced traders.
Hedging is a risk management technique used to reduce losses. They resort to it to protect their profits, especially in times of uncertainty. Abstractly, the idea is that if one of your investments loses, then you have an alternative hedged position to offset the loss.
Thanks to the use of CFDs, you get ample opportunities for hedging, since the possibility of opening short positions is available for all CFD instruments.
For example, you have built a long-term portfolio of blue chips, however, the market begins to decline and you begin to worry about the value of your portfolio.
With leverage, you can short an index of a relevant market to hedge against losses if a downtrend begins. Accordingly, when the market declines, whatever you lose in your main portfolio will be offset by your hedge. Conversely, if the market continues to rise, then you will lose on the hedged position on the index, but will earn on the securities themselves.
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CFD according to official rules
What is CFD
as defined by major organizations such as the Financial Conduct Authority (FCA), the European Securities and Markets Authority (ESMA), the Markets in Financial Instruments Directive (MiFID) and the Cyprus Securities and Exchange Commission (CySEC)?
✅
According to
the ESMA definition
(as of March 26, 2022), translated into Russian, a CFD is an agreement between a “buyer” and a “seller” to trade the difference between the current price of the underlying asset(s), (share, currency, commodity, index, etc.) and its price at the time of closing the transaction.
✅
According to
the CySEC definition
(see March 26, 2022), translated into Russian, CFDs are agreements between two parties to trade the difference between the current price of an underlying asset (which can be a share, currency, commodity, index, etc.) and its price on the day of expiration of the contract. Profit or loss is calculated at the time of termination by multiplying the difference between the two prices by the number of CFDs traded.
✅
As defined by
the FCA
(26 March 2022), CFDs are complex leveraged derivatives. They are typically offered to retail customers through online shopping platforms.
Thus, a CFD is a derivative product that transfers to its holder the economic risk of changes in the price of the underlying asset, calculated as the difference between the price of the underlying asset at the time the agreement is entered into and its price at termination of the agreement.
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How does CFD work?
A CFD contract allows you to open a buy or sell trade. In this regard, CFDs allow you to potentially make a profit both from an increase in the quotes of a trading instrument, and from their decrease. Below is an explanation of how CFD works.
✅ Let's take the example of Hermès (RMS) stock price growth to understand how CFDs work. If a trader expects Hermès to rise in price from €850 to €950 in the future, he can open a buy position at €850 and then close that position at €950 for a possible profit.
In this case, the meaning of the transaction is not much different from the traditional acquisition of shares. However, what if a trader predicts a decline in stock prices?
In this case, he cannot “sell” the common stock in the traditional way. Here he can use CFDs to sell.
✅ Take, for example, the fall in prices for Hermès shares. If a trader predicts that quotes will fall from 850 euros to 750 euros, then if the forecast is correct, he can potentially profit from this movement. To do this, he needs to open a short position on a CFD on Hermès shares at a price of 850 euros and set Take Profit at 750 euros.
| ✍ Conducting such transactions on the stock market is impossible without the use of derivative financial instruments. However With the help of CFD contracts, it becomes possible to make a profit even when the price falls . |
For example, in the event of a stock market crash, it becomes possible to make potential profits from falling prices of individual stocks or stock indices. In other words, if S&P 500 stock index prices begin to decline rapidly, traders who entered short S&P 500 CFD trades at higher levels could profit.
❗It is important to remember that CFD trading always involves risk, so any financial decision should be carefully considered.
Advanced tools for analysis and trading are presented in the trading platforms MetaTrader 4 (detailed guide to MetaTrader 4) and MetaTrader 5 (detailed guide to MetaTrader 5).
✅ You can also additionally install our exclusive MetaTrader Supreme Edition plugin for the MT4 and MT5 platforms presented above.
Dividends on shares
If you bought a CFD on a share on Forex, you will be able to qualify for dividends - just like when buying options and futures. Each broker solves this issue in its own way, but more often the following scheme works:
- if on the cut-off date a CFD contract is purchased (a long position is opened), then dividends are calculated and added to the account;
- if the contract is sold (short position is opened), then dividends are debited from the account.
The dividend is calculated per share. Exactly how much will be accrued or withdrawn is calculated from the contract specification. Usually there are 100 shares in one lot. Therefore, if the dividend is $2, then when you buy a CFD you will earn $200 on the whole lot, and when you sell you will lose $200.
Therefore, most traders try to close short positions before the cutoff to avoid paying extra money. On the other hand, you can earn much more from the dividend gap after the cutoff than you can lose. So it all depends on the strategy.
CFD chart
Source: Admirals, MetaTrader 5, Tesla Motors Inc. stock performance, daily chart with data range February 18, 2022 - March 18, 2022. Accessed March 18, 2022. Please note that past performance is no guarantee of future results.
The above figure shows the stock price performance of Tesla Motors Inc. (#TSLA) over a 13-month period. During this period, Tesla shares made tremendous gains with periodic corrective movements. CFDs, by definition, allow you to make money on both rising and falling Tesla stock prices.
Tesla Motors Inc. shares (#TSLA) are selected solely for the purpose of demonstrating technical analysis tools and do not constitute investment advice.
