CFD, or contract for difference, trading is not very new, but it is pretty new when it comes to its usage by the every day trader. CFDs have existed in the financial markets for years, but until just recently, they were a tool used almost solely by professionals. Today, thanks mostly to the internet, CFDs are available to almost anyone.

What is a CFD?

If you have traded in the Forex market before, then you are already familiar with trading CFDs. A contract for difference is a trade that uses bid and ask prices, much like the Forex market utilizes. The big difference is that it utilizes assets outside of the world of currency. You can find stocks, indices, and commodities in the CFD market. This is a way for those that focus on the Forex market to extend their trading capacity, all without finding a new broker to do business with. It’s definitely not a Forex trading tool, but it uses very similar methodologies when it comes to how traders approach it.

Interest Rates

If you leave a Forex trade open overnight, most brokers will charge you interest. The going rate varies, depending on what pair you are trading and which broker you use, but you will be charged interest nonetheless. A lot of people new to trading do not understand why this is, but the concept is actually pretty simple. You aren’t being charged interest because of the fact that you leave a trade open, but because of the fact that you used leverage. Leverage is a way to increase the size of your trade, but it essentially uses borrowed money to do so. If you look at it this way, it would be foolish of the brokers not to charge you interest for borrowing their money.

And that’s how CFDs work, too. Depending on the broker, you may be charged an interest rate for trades that are left open overnight, or you might be charged an interest rate for all trades. It depends on where you trade. The going rate will also vary from broker to broker and depending on the popularity of the asset that you’re focused on.

Trading CFDs

The concept of executing a CFD trade should be familiar to you by now. What might be more of a mystery at this point is how you actually make a trade. Let’s look at this in a little more detail.

The bid and the ask prices that you are familiar with when making a traditional Forex trade are going to be very similar. You buy your contract at a lower price, and then cannot make an immediate profit on it because the selling price is higher. The set up of these prices will be slightly different than you might be used to, but the basic idea is the same. If you are unsure of the process, be sure to use a demo trading account as you are gaining familiarity with the process so that you are comfortable when it comes time for you to make a real money trade. Most brokers will allow you to use their MetaTrade platform to do this, but if you have any trouble with this process, be sure to get in touch with your broker’s customer service department. They can walk you through the process of executing CFD demo trades so that you can gain some mastery over them.

An Example

Let’s look at a quick example. The mechanics of how this trade might actually look on your trading platform will vary, but the basic premise will remain the same.

If you are trading the S&P 500, the bid price might start out at $2,000.00 per contract. Now, you’re not likely to have spent $2,000 on this contract because of leverage, but that’s a different story. If you are buying the contract at that price, it’s likely that the asking price—or sell price—is going to be a bit higher. Usually, this can range anywhere from 1 percent to a bit higher or lower, but again, it depends on what broker you use.

In this case, if you sell your CFD right away, you are netting a loss of 1 percent. You would have to wait for the bid price to rise up above $2,020.00 to sell if you want to breakeven because this is the point that the ask price would hit $2,000 even with a spread of exactly 1 percent. Once the ask price rises up above the original bid price, you have now made a profit. The size of your profit will depend on the amount of leverage that you’ve used and the exact amount that the trade closes at.

Risk Management

You wouldn’t enter a Forex trade without making sure that you were protected if things started moving against you, right? You need to make sure that you’re doing the same when you are trading CFDs. We’ve all seen those instances where a trade seems like a surefire deal, and then all of a sudden, it goes in the opposite direction of what was expected. That’s the nature of the markets—any marketplace. Placing the proper stop-loss measures well ahead of time will ensure that if something like this happens, you aren’t stuck losing a lot of money. When leverage is involved, even a small loss can be a big one.

If you are trading with a demo account, this is the perfect place to practice your stop-loss measures. In fact, we highly stress that you practice first if you’ve never traded with CFDs. This will be the easiest way to get a feel for what you’re doing without putting your cash at risk.

The Final Word

CFD trading possesses a lot of potential for traders, but it’s certainly not for everyone. For those that already have experience with Forex trading, this is a familiar way to also gain access to many more different assets. And like any other type of trading, there can be a lot of risk in the CFD market. There’s a lot of preparation that you need to take into account before you start looking at bigger trades, but this is a trading method that holds a lot of potential. If you’re going to trade, prepare yourself. Use our tools to gain the information and knowledge needed to be successful, and then approach it as preparedly as possible.