What is CFD and How Does it Work?

A Contract for Difference, often referred to in the world of finance as a CFD is a type of derivative – this means an investment in which you do not own any assets, but you speculate on the value of a specific type of investment. A CFD is basically an agreement between a trader and their broker, based on the change in the price of an asset, usually over a relatively short time period.

There are various types of contracts for difference, including:

• Stocks

• Indices

• Commodities

• Foreign Exchange Pairs

One of the appealing elements of CFD trading is that it's possible to speculate on the way the price of an asset is going to go, whether you are expecting it to go up or down. You can also trade CFDs using leveraged trading, which means you only need a fraction of the value of your trade to open a position, making more global markets accessible to those with limited initial capital.

How does CFD trading work?

To trade in CFDs, you choose how many contracts you want to buy or sell, which is known as 'opening a position'. If you have chosen correctly, the markets will move in the direction you predicted, and your profits will increase every time the market moves a point in your favour. 

For an asset that you believe is going to increase in price, investors will want to buy in order to capitalise on the increase in value. This is known as opening a 'long' position and you can make profits when assets do increase in value but lose money if their price decreases.

Similarly, if you believe that the price of a particular asset is about to fall, you would open a short position so that you profit if the market does drop in line with your prediction. Of course, this also carries the risk of losing money if the asset increases in value.

How do you trade in CFDs?

Trading CFDs allows you to use leverage in order to trade using only a small fraction of the value of the trade, which is known as a deposit margin. Brokers that offer traders the option for margin trading will usually want to know more about potential traders before they allow them to trade. 

To get access to many CFD trading platforms, traders will need to supply proof of their identity and evidence that they have the funds required to cover their accounts. Many brokers offer the option to complete test trades in a demo account to assess the features and learn about the reporting functions and ability to extract useful information. 

Some brokers operate in jurisdictions that require new customers to be tested on their suitability before being allowed to trade in CFDs. The test is designed to ensure that traders understand the risks associated with trading on a margin, but it is important for any potential trader to fully research the process of trading before investing any money into CFDs. 

Leveraged CFD trading

Leverage in CFD trading means that a trader only needs a small percentage of the total value of each trade, and the rest is loaned to them by their broker. The percentage that the trader needs to have to complete the trade varies depending on their broker, their contract, and the asset that they want to trade in. 

This process is also known in the world of finance as trading on a margin, usually in the context of a margin percentage that represents how much of the total the trader needs to deposit. When it comes to CFDs, there are two prices for each asset: the ask price, or buy price, and the bid price, or sell price. 

Although these are both based on the underlying value of the asset in question, the ask price will always be slightly higher than the underlying value and the bid price will be slightly lower. The difference between the two is known as the CFD spread.

Traders can profit when they correctly predict whether an asset will rise or fall in value. There are a number of factors that can affect the price of some of the most traded global assets, including:

• Government policy changes

• New technology

• Awarding of large contracts

• Regulatory changes

• Extreme weather events and natural disasters

• Legal challenges

• Industrial innovation

• Shortages of raw materials

• Recruitment problems

Traders that have specialist industry knowledge can make the most of their experience to predict the potential value of related assets, but any trader will also need to pay attention to world events to inform their trading strategy. CFD trading can be an ideal way to benefit from your knowledge and understanding of the markets.