Education > Basics > What is contract for difference (CFD) and how does it work?

What is a contract for difference (CFD) and how does it work?

CFD trading is a popular way to speculate on the price of assets such as stocks, indices, commodities, forex, and cryptocurrencies without actually owning them. This is done through financial derivatives known as contracts for difference (CFDs).

What is CFD?

A CFD is a type of contract between a trader and a broker, where they agree to exchange the difference in the value of an underlying security from the beginning to the end of the contract. CFD trading allows traders to go long or short on assets and take advantage of rising or falling prices over a short period of time.

The advantage of CFD trading is that it allows traders to take positions in the market without having to purchase the actual assets. This means that traders can gain exposure to a wider range of markets and assets than they might otherwise be able to.

It’s important to note that CFD trading involves risks and is not suitable for everyone. Traders should educate themselves on the risks involved and use proper risk management techniques to protect their capital. With that said, CFD trading can be a useful tool for those looking to diversify their portfolio and potentially profit from market movements.

A CFD is:

– a financial derivative in which you do not own the underlying asset. I
– it is an agreement between you and your broker to exchange the difference in the price
– it is based on the change in an asset’s price, and it is typically conducted over a short period of time

What are CFDs?

CFD trading allows traders to use leverage, which means they can open larger positions than their initial capital may otherwise allow. However, traders should be aware that leverage can increase both profits and losses.
One of the advantages of CFD trading is the ability to speculate on an asset’s price movements in either direction. Traders can open long or short trades depending on whether they believe the asset’s price will rise or fall, respectively.

While CFD trading offers traders greater exposure to global financial markets, it also involves risks and is not suitable for everyone. Traders should educate themselves on the risks involved and use proper risk management techniques to protect their capital.

How does CFD trading work?

To start CFD trading, you select the number of contracts (the trade size) you want to buy or sell. When the market moves in your favor, your profit rises in line with each point of movement. However, there is a risk of loss if the market moves against you.
Traders can either open a long (buy) position if they believe the price of an asset will rise, or a short (sell) position if they think the price will fall.

Profits are made if the asset price moves in the predicted direction, but losses can occur if the prediction is incorrect.

What is a CFD account?

A CFD account allows you to trade on the price difference of underlying assets using leverage, where you only need to put up a fraction of the amount needed to trade, known as deposit margin. The maintenance margin, which is covered by equity, needs to be maintained to keep positions open, and it changes based on asset prices.

It’s crucial to keep your account’s equity above the maintenance margin to avoid a margin call and ensure that your positions remain open, especially during running losses. CFD trading involves risks and is not suitable for everyone, so you should educate yourself on the risks involved and use proper risk management techniques to protect your capital.

Your broker requires some information about you before offering margin trading. To set up an account, you need to provide proof of identity and evidence of your ability to cover losses. You can practice trading in a demo account, but a live CFD trading account requires adding funds.

What is leverage in CFD?

When you trade CFDs, you have the opportunity to use leverage. This means you only need to put down a fraction of the value of the trade, with the rest being borrowed from your broker. The amount of margin required can vary, but it’s important to remember that leverage can increase both profits and losses.

For instance, if your broker requires a 10% margin and you want to open a trade for $1,000-worth of silver, you only need to deposit $100 to open the trade.

Spread and commission

CFD trading involves two prices: the buy price (ask) and the sell price (bid) based on the underlying instrument’s value. The buy price is always higher than the current value, while the sell price is always lower, with the difference called the CFD spread. Jetvix doesn’t charge CFD commission for opening or closing trades.

The ask price is used to open a long position, while the bid price is used to close it, and vice versa for short positions.

To illustrate this idea, if you purchase 100 CFDs on silver at $1,200/$1,205 (bid/ask), you take a long position. If silver’s price rises as you anticipated, you make a profit.

Note that trading always involves risk.

What assets can you trade with CFDs?

At Jetvix, you have access to a wide range of CFD assets, including shares, indices, cryptocurrencies, commodities, and currencies. We offer thousands of different CFD options across these classes, enabling you to trade the world’s most popular markets all in one place. Our range of available CFD options is constantly expanding.

Example of going long CFD trading

You believe that Tesla’s stock is going to increase in value and you decide to open a long CFD position. You purchase 50 CFDs on Tesla at $700 per share, for a total value of $35,000.
If the stock price of Tesla increases to $800, you would make a $100 profit per share, or a total profit of $5,000. However, if the stock price falls to $600, you would incur a $100 loss per share, or a total loss of $5,000.

Here are the steps of the possible trade:

The share price of Tesla is $700. You begin to watch the market.
The share price of Tesla increases to $710. You decide to buy 50 CFDs on Tesla.
The price of Tesla’s stock continues to rise and reaches $800. You close your trade by selling the 50 CFDs, making a profit of $100 per share, or a total profit of $5,000.
It’s important to keep in mind that all trading involves risk, and it’s possible to incur losses as well as gains.

Example of going short CFD example

You think the Tesla stock price will fall. You can open a short CFD position. This is known as short-selling.

You decide to sell 50 CFDs on Tesla at $600 per share. The total value of the trade is $30,000. The price falls to $550, giving you a profit of $2,500 or $50 per share. However, if the price rises to $650 per share, you would lose $2,500, or $50 per share.

Example steps of that possible trade:

The share price is $590. You start looking at the market.
The price of your CFD rises to $600. You open a trade (sell the CFDs).
The price falls to $550. You close your trade (buy the CFDs). Please note that there is always a risk of loss with any trade.

Example of margin trading

Margin trading, also known as leveraged trading, is a type of CFD trading that allows you to open and maintain a position using only a fraction of the total trade size. The funds required to do this are known as the CFD margin.

There are two types of margins to be aware of when trading CFD shares. The deposit margin is the initial amount required to open a position, and the maintenance margin is the equity required in your account to cover potential losses if the market moves against your trade. The margin required can vary between asset classes and within different regulated areas.

For example, let’s say you buy 100 CFDs on Tesla at $650.50. With a 20% margin requirement, your initial outlay would be $13,010 ($650.50 x 100 shares x 20% margin). If Tesla’s stock price rises to $700, and you decide to sell, your profit from this trade would be $4,990 ($49.90 x 100 shares = $4,990).

However, it’s important to note that there is always a risk of loss when trading with margin.

Profit and loss

After you have identified a potential trading opportunity, you can open a position in a CFD. Your profits or losses will track the underlying asset’s price in real time from that point on. You can keep track of open positions on the trading platform and close them at your convenience. Your profit or loss can be calculated by multiplying the difference in price by the number of contracts you hold, using the following formula:

P&L = number of CFDs x (closing price – opening price)
For example, if you purchased 1,000 CFDs on Tesla at $600 per share and sold them at $700 per share, your profit would be $100,000.

However, keep in mind that there is always a risk of loss associated with trading.

Stops-loss and take-profit

It’s important to note that setting up stop-loss and take-profit orders does not guarantee a profit or prevent a loss, but they can help manage risk and potentially limit losses. Stop-loss orders automatically close a position if the market moves against you, preventing further losses beyond a predetermined level. Take-profit orders, on the other hand, automatically close a position once it reaches a certain profit level, allowing you to secure gains without having to constantly monitor the market.

Guaranteed stop-loss orders are a type of stop-loss that ensures that your position will be closed at the exact price you specify, even in the event of slippage. However, they come with a higher cost due to the added security they provide.

Using these risk management tools can be an effective way to manage your CFD trading, but it’s important to set them up properly and keep an eye on the market to adjust them as needed. Remember to trade with your head and not your heart, and always be prepared for the possibility of losses.

Negative balance protection and margin closeout

CFD brokers have a regulatory obligation to offer negative balance protection to their clients. This protection ensures that a trader’s account balance will not go below zero, even in volatile market conditions. Jetvix is a CFD broker that offers negative balance protection for its clients’ accounts. In order to keep positions open, a trader must meet the maintenance margin requirement. The maintenance margin is the minimum amount of equity that must be maintained in the account to keep the positions open.

The margin account’s value acts as collateral for credit, and if the account equity falls below the maintenance margin, a trader will receive a margin call. A margin call is a notification that requires the trader to either top up their balance or close some of their positions to reduce their exposure.

If a trader does not respond to the margin call, and the close-out level is reached, Jetvix will initiate a gradual close-out procedure on the trader’s positions. With negative balance protection, a trader can be assured that their account balance will be corrected if it drops below zero.

It is essential to practice risk management techniques when trading CFDs, especially on highly volatile assets. Before trading, it is crucial to understand how CFDs work and to consider whether you can afford the risks that come with CFD trading.