Many Forex brokers offer – in addition to trading foreign currencies – CFD (Contracts for Difference). In this article, we will explain you how CFD work and tell you the advantages and disadvantages of trading CFD.
How CFD (Contracts for Difference) Work
When you buy an option you have the right to buy the underlying stock (eg, Vodafone’s shares) at a specified price (you are “long” and have a call option) or to sell the stock at a certain price (you are “short” and have a put option).
With a Contract for Difference (CFD), in contrast to stock options, you only deal with the difference in the price of the underlying value. Unlike options, CFDs don’t have an expiry date. Accordingly, there is no time value in CFD: the prices of CFD are moving in parallel to the underlying value.
As with Forex, CFD can be bought on margin, i.e. with a leverage. This opens up the field for huge profit opportunities, either when you are “long” and you speculate on rising prices, or if you are “short” and speculate on falling prices. The risks are correspondingly enormous as well: if the value of the CFDs is not covered by your margin anymore, then the FX broker usually closes the position and you lose your invested capital completely.
You buy a CFD on 10,000 Vodafone shares. The stock price is currently € 2.00 per share. The leverage is 20:1 and you invest € 3,000. So you speculate with Vodafone shares worth € 60,000 (€ 20 x 3,000), equivalent to 30,000 stocks. If the price of Vodafone shares increases on the same day by 1.5% to 2.03, then you have generated a profit of 30,000 x 0.03 = € 900. You can also calculate the profit by multiplying the invested capital, leverage and price increase as follows: 3,000 x 20 x 1.5% = € 900.
Note that your invested capital of € 3,000 is lost if the Vodafone share decreases by 5%. The use of stop-loss orders is therefore usually a recommended tool to limit you losses.
With most Forex brokers you can trade CFD without having to pay a commission. As with Forex trading you pay the fees indirectly with the spread. The spread is the difference between the bid (buying) and ask (selling) price for a CFD. If you hold a CFD overnight, then you will also have to pay a “rollover charge” (interest).
CFD Advantages and disadvantages
As a trader you can go long or short. So you can earn money with increasing and decreasing stock prices.
Thanks to the leverage you can use much less capital to earn money with CFD than when you buy the stock. Typical margins on CFDs range from 1:10 to 1:100. Note that the larger the leverage, the higher the risk of a total loss generally is. If the FX broker automatically closes the position when the margin is used up, then the downside risk is limited to the invested capital. CFDs have – as opposed to options – no time value.
The costs for CFD trading are relatively low. You don’t have to pay a commission to your Forex broker, the only “cost” is the spread between the buying price and selling price of the CFD.
Transparency: Because CFD are tied to a real value, the price movement of CFD transparent and easily understandable.
Offerings: In addition to individual stocks also indices and commodities like oil and precious metals can be traded online. CFD are usually only available for liquid and often traded underlying values, such as the stocks of companies that are represented in the NYSE.
Risk: Due to the leverage effect, the risk of a total loss with CFD is huge. Before you start trading CFD with real money, you should understand this financial instrument and its risks.
Tip: Open a free demo practice account with AvaTrade to get more familiar with CFD without risking any real money!