Demystifying CFD Trading: Understanding The Basics and Using the Knowledge to Your Advantage
Why CFD trading? That is the questions most traders and aspiring traders ask, followed by how is it any different from currency trading or stocks exchange? These questions have dominated the finance forums, particularly in the last decade as CFD trading has become more popular.
In the simplest of terms, understandable even to beginners; here is a CFD breakdown that will help you make the best decision when determining if CFD trading is a profitable venture.
What is CFD Trading?
First things first, CFD is an acronym that stands for Contract For Difference. Before digging further into this definition, it is important to note that CFD trading is very similar to forex exchange.
That means in both forex exchange and fx cfd trading there is no transfer of physical assets since transactions are over a network of financial institutions. Second, both forex and CFD trading occurs over similar platforms. It is actually common to find platforms that offer both and it is up to the investor to determine which they prefer.
With that context established, it becomes easier to understand CFD trading. A CFD is a contract between the two main players in trading: the broker and the investor or trader. The contract stipulates that from the moment a trader enters the market and until the moment they exit, the difference attained will be exchanged between the broker and the trader hence Contract For Difference.
The contract can quote any global financial market the trader is interested in because CFD trading is not limited to one market. The reason CFD trading is not limited to a single market or a single asset is that the underlying asset is not important and the only thing that matters is the changes in prices of a given asset as the market rises or falls.
That means a CFD can cover shares, currency, treasuries, indices or commodities. As the trader, you do not buy or sell an actual asset, but you buy or sell a number of units of a given asset depending on whether you think the prices will rise or fall. Four units of particular shares, for instance, or ten units of a certain currency pair.
So, if you take the example of a contract that quotes the stocks exchange; then unlike the stocks exchange where a trader owns a piece of the company by buying the shares, in this case, you simply speculate whether the shares will go up or down and if they do so in your favor, then you gain a profit.
How Do People Make Money in CFD trading?
Whenever a trader buys certain units of a given asset and the price of that asset goes up within a certain time frame, then the trader earns the price difference which is multiplied by the number of units purchased.
Similarly, if the asset price goes down, the trader has to pay the broker the difference.
If you are wondering how the broker benefits, then they do so via the spread. In any contract bought, the trader covers the spread.
What Are The Differences Between CFD Trading and Forex Exchange?
Noted above, were the similarities of CFD trading and forex exchange. There are some key differences one ought to note as well.
- Forex markets are open 24 hours a day while CFD trading will depend on the underlying asset or market.
- The price variations in CFD trading are dependent on the supply and demand of the underlying asset while price variations in forex exchange are determined by factors such as policies.
- CFD trading, as mentioned above is not dependent on one market.
What Is Right For You and Why Do Some People Prefer CFD Trading?
Those who prefer CFD trading do so for two main reasons.
- The fact that CFD trading covers various markets makes it easier to make a profit because some markets are naturally more favorable than others.
- The margin for CFD trading can be as low as 5% depending on the broker unlike in forex exchange where it is often higher.
With that knowledge in mind, you can now determine which would work best for you.