What is a CFD? Contracts For Difference Explained

September 20, 2021
Reading Time: 9 min
What is a CFD? Contracts For Difference Explained - cfd e1594909790475

CFD trading may not sound like much at first, but it opens traders up to an entire world of possibility in terms of trading assets and finance.

CFD is an abbreviation for a contract for difference. It is essentially an agreement between two parties, usually, a buyer or seller, where the buyer will pay the seller the difference in value between the current asset value (also called closing price) and the asset value as the time the contract was made (also called opening price).

How Does CFD Trading Work? Contracts For Difference Explained

CFD trading works by brokers developing a popular form of derivative, taking an underlying market, and making a new trading instrument. This new trading instrument isn’t bound to the same rules of a spot trading exchange, where traders can only buy or sell an asset that they then own.

Because CFD trading relies on derivatives, new and even exotic trading instruments can be designed. CFDs can be anything but are most commonly traded as forex, stocks, stock indices, commodities, or cryptocurrencies.

CFD Trading vs. Traditional Trading: What You Need To Know

With CFDs, the underlying asset isn’t owned and no actual assets ever change hands. Only the base account asset the contract is settled in is ever impacted in any way.

Due to this design, CFD trading doesn’t rely on spot buying or selling to make a profit, and instead is called a long or short position. If a trader uses CFDs to trade a specific market and expects an asset to go up, rather than buying the asset and holding it, the trader would open a long contract at the current market value, and then settle it at a bid price they are comfortable with. Any remaining difference gets booked as profits, hence the name, contract for difference.

Advantages of CFD Trading: The Pros of Professional Trading Instruments 

CFDs offer many advantages over traditional trading, First and foremost, by never being exposed to owning any of the underlying assets, it is easier to get in and out of positions more fluidly.

CFDs are highly liquid contracts that allow for lightly fast order matching offering unrivaled speed for active traders. These orders also open or close with minimal spread or price difference.

CFDs can be traded as long or short positions, be held open simultaneously for hedge positions, and leverage can be applied for a more dramatic impact on profit margins.

Risks and Risk Management: How To Protect From Loss

Due to leverage or contract size increasing the impact of a CFD’s ability to amplify profits significantly, it also can greatly enhance losses.

Therefore, it is even more critical to employ risk management strategies and take extra caution when trading CFDs. Traders need to fully understand the contract they are entering and all it entails and also be well-versed with risk management strategies to ensure that their positions and capital are properly protected.

Risk management strategies include only wagering so much per position to establish a winning risk to reward ratio, setting stop losses, or even performing technical analysis to get a read on the market before taking an entry.

Successful risk management strategies vary, but the most successful traders never forget them and don’t stray far from their trading plan. It is also recommended to use a trading calculator to prepare each position properly and know exactly what you are about to enter for a contract.

Forgetting a stop loss using high leverage could create a risk of losing it all. It’s important to never forget this critical step. By having a stop loss in mind in advance, once it’s set, you will be less apt to make changes or panic in the moment of strong volatility.

Unfortunately, due to the high risk associated with CFDs, they are not always available in the USA.

Short and Long CFD Trading Explained: Profit From Any Direction

One of the most glorious aspects of a CFD trading platform over traditional trading platforms is the ability to long and short markets rather than buy or sell.

When buying and selling, there is only the ability to profit while prices are rising. Traditional market traders sell their assets when they expect it to fall in value, then later buy it back when the price has fallen low enough again to become attractive as an investment.

With long and short positions, traders can generate profit from both rising and falling markets, and always be ready for an opportunity no matter which way the market turns next.

Short and long trades can be held simultaneously, at different prices, and with different targets. This also allows for hedge positions and other advanced trading strategies.

If markets are falling, a trader would want to open a short position, then close it when the price has fallen sufficiently either to support or until the desired profit is generated.

If markets are rising, a trader would open a long trade in anticipation of the price going up. Once it reaches the target resistance or profit, the trade can be closed and profit is booked.

If the trader is wrong in their prediction and their position goes against them, either a stop loss will be triggered or traders can manually close out at a loss.

The win to loss rate and total profit or loss will ultimately determine if a trader is successful or not. This is why risk management strategies are especially important. Even when things don’t go your way, losses can be minimized and with the right strategy, it would take as many as 100 consecutive losses to fully drain an account.

Leverage and margin trading can enhance the risk associated with these types of trades, however.

What Are Margin and Leverage?

Margin and leverage go hand and hand, and they often get confused or are used interchangeably albeit incorrectly.

Leverage is a tool for advanced traders that gears their capital to greatly amplify the return on price movements, by multiplying them by a certain amount.

Margin is required for leverage. An account must have capital deposited that acts as margin. This margin is used as collateral to multiply position sizing.

For example, a 0.01 BTC trade at 100x leverage, would result in a position size of 1 BTC. In USD terms, a $100 trade at 100x would turn into a $10,000 trade.

Leverage on CFDs ranges from 3x all the way to 1000x on more stable forex currencies. This is how traders squeeze out more profit from the normal stable market. Cryptocurrency, like Bitcoin, however, is more commonly traded at 100x due to how highly volatile the asset class is.

All CFD trading accounts will want to keep enough margin allocated to cover all trades, as well as added margin to protect from liquidation in case a trade goes in the wrong direction.

More margin is required for larger positions sizes or more positions overall. If not enough margin is held, first, a margin call will act as a warning. Then, liquidation of all open positions will occur to cover the total margin required to settle all positions. Any remaining margin will be returned to a user’s trading account balance.

The reason any trader would want to utilize leverage comes down to profits. Leverage raises the stakes and makes trading high risk and high reward.

In previous examples, $100 was used that was turned into $10,000. But when $10,000 is then turned into a position size as $1 million, you start to see the power of something like 100x leverage.

Using these figures, a $10,000 trade in Bitcoin, now valued at $1 million, moves 20%. This type of move isn’t uncommon for the cryptocurrency intraday.

At $10,000 a 20% move would result in a $2,000 gain for a total of $12,000 in account balance after the close. With 100x leverage, the 20% gain becomes a 2,000% ROI. The closing value of the same trade using leverage is $200,000, taking the account balance to $210,000.

When the position is closed, the margin used as collateral to multiply the power of the trade disappears, but the profits remain.

It is important to remember, though, that although the profit generated can be extreme, this also means that losses are also multiplied.

This makes things like risk management strategies and strategic stop loss placement that much more important and crucial to trading plans.

How To Start Trading CFDs

Now that you can clearly see the benefits that CFD trading platforms have to offer over traditional trading platforms, here’s how to get started. In very little time and only a few steps, you can get registered on a reliable platform, make a deposit, and go from position to profit.

Step 1: Create a CFD Trading Account

Traders can sign up for a trading platform of a CFD broker that offers a free demo account before beginning to trade on a live account. PrimeXBT is an award-winning Bitcoin-based margin trading platform offering CFDs across a variety of financial markets, including forex, commodities, stock indices, and cryptocurrency assets.

Registration is simple, takes less than one minute, and offers an easy to use Bitcoin-based trading account. Your trading account balance is denominated in BTC, protected by bank-grade security and other preventive measures such as two-factor authentication and compulsory address whitelisting.

What is a CFD? Contracts For Difference Explained - image2

Step 2: Make Your First Deposit

PrimeXBT offers a low minimum deposit of just 0.001 BTC to get started. Funding your account is an important step and gets you even closer to diving into markets.

It is important to both be comfortable with your first deposit but ensure you deposit enough to avoid a margin call due or falling into a negative account balance. Some platforms, however, offer negative balance protection. You also need more capital depending on the amount of trade volume expected.

Also, keep in mind most CFD brokers include a commission charge on each trade, and others even include a financing or funding fee for keeping CFD positions open using collateral.

What is a CFD? Contracts For Difference Explained - image1 e1594818807815

Step 3: Plan Your Trading Strategy

Coming up with a trading strategy that brings regular success is much more difficult than it sounds, however, it is possible with time, skill, practice, and expertise. Of course, luck can be a factor as well.

Performing technical analysis to establish a buy price in which to enter and sell price at which to exit is paramount to success.

Once a plan is in place, it’s time to take a position.

What is a CFD? Contracts For Difference Explained - image3 e1594818824703

Step 4: Take a Position

Prepare the position you want to take by entering the desired entry price. If the price is close, you may want to consider entering the trade immediately through a market order. Otherwise, choose a limit or stop order and submit your order.

When the order has filled, enter a stop loss, and then the final step is next.

Step 5: Take Profit

All that’s left, unless your stop loss is triggered before this point, is to take profit once a desired level or target is reached.

Taking profit often and even early is recommended. This way if the market turns back the other way, you close the trade in profit and not at a loss.

CFD Trading Strategies

The two most common ways to trade CFDs is through day trading or swing trading. Both techniques have their own set of pros and cons, discussed below. The same tools and risk management should go into both types of trading techniques despite the differences. These basic building blocks of trading shouldn’t change.

Day Trading CFDs

Day trading involves high frequency, short term trade durations often in the same day or trading session.

Day traders prefer the fast-paced thrill of shorter timeframes and more active trading techniques. Technical analysis indicators are the same across both day trading and swing trading, however, day traders focus more on timing, moving averages, or overbought and oversold conditions, instead of trend measuring tools.

The quick, in and out action of day trading is perfect for the speedy contract settlement of CFDs and the platforms offering them. These types of contracts are designed with speed and efficiency in mind.

And by getting in and out to rates in rapid succession within the same day or trading session, day traders can avoid overnight finance fees in addition to commissions.

Swing Trading CFDs

Swing trading focuses more on medium to long timeframes such as daily and weekly timeframes. Typically trades don’t last more than a few weeks and rarely extend beyond two months unless an already open position begins to trend strongly and stops are moved down in profit accordingly.

Otherwise, swing trading takes place at medium-term trend peaks and troughs. Swing trading refers to the more common, buy low and sell high strategy form traditional markets, but medium-term long and short trades through CFDs are also possible.

Some trading platforms may charge an overnight financing or funding fee, in addition to commissions at the time trades are opened. That should be taken into consideration when planning swing trades. Therefore day trading is often considered the ideal trading technique for CFDs. However, this is not a rule and depends on many factors especially personal taste.

Bonus Tips For Trading CFDs

  • Always utilize a trading calculator before taking any position.
  • Start slow and get comfortable with this type of high-risk, high-reward derivative trading product.
  • Find a trading platform or CFD broker with a positive reputation, powerful trading tools,and reliable security.
  • Decide ahead of time which markets you want to trade before choosing a platform. It will make the decision that much easier. 
  • Select a platform with many CFDs across a variety of markets under one roof. You can start with one trading instrument and later try another.
  • Be sure to regularly use proper risk management strategies. Always set a stop loss. If using leverage, take this into consideration when calculating potential loss as well as profit.
  • Use leverage carefully. It can lead to complete capital loss if not careful or if a mistake is made.
  • Always keep extra margin in your account in case an opportunity opens up or a position goes against you. This will prevent a margin call or liquidation.
  • Experiment with many types of CFDs and underlying asset markets. The flexibility of these contracts make for some interesting trading opportunities.
FAQ: Frequently Asked Questions

What does CFD stand for?

Contracts for difference.

What is the definition of CFD?

A type of agreement or contract where two willing parties, a buyer, and a seller agree to settle the contact based on the price difference between the time the contract was opened and at the time the position was closed. Pricing is based on the market price of the underlying asset of the trading instrument.

Which CFD markets can I trade on?

CFDs are available for any type of market, from traditional to digital assets. Most commonly CFDs are found across forex, stock indices, commodities like gold and silver, and cryptocurrencies like Bitcoin and Ethereum.

Is CFD trading right for me?

CFD trading is right for anyone, so long as a trading calculator is used so traders fully understand all aspects of their position, including potential profit, the risk to reward, any loss if a stop loss is triggered, and more. Never take position sizes larger than you can stand to risk or lose, and be sure to stick to the trading plan at all times.

Is CFD online trading safe?

Yes, depending on the trading platform selected. PrimeXBT utilizes many safety features that protect user funds and keep accounts secure.

What is CFD leverage trading?

Leverage trading uses margin to use as collateral when taking position sizes much larger than the capital would otherwise normally allow for. This lets traders gear their trades and greatly amplify any profits generated from each position. This also will increase risk so prepare accordingly.

What is trading long and short?

Long and short lets traders profit whichever way markets turn. Long and short positions are just one of the most important benefits of CFD trading.

How do I use CFDs for hedging?

CFD hedging involves opening a short position in an asset that is also a long term hold as an investment. For example, a trader holds Bitcoin, and both fear a crash is coming but don't yet want to set until there’s more confirmation a trend change is underway. At the first sign of reversal, a trader can open a hedge short position, and profit from any drawdown before they make up their mind as to what to do with their long term investment holding. It is a great way to protect and even grow capital in the short term during crashes or downtrends.

What is PrimeXBT?

PrimeXBT is an award-winning Bitcoin based margin trading platform offering CFDs across forex, stock indices, commodities, and cryptocurrencies. Forex includes all major currency pairs. Stock indices include the Dow, S&P 500, FTSE, Nikkei, and many more. Commodities include oil and gas. Cryptocurrencies include Bitcoin, Ethereum, EOS, Ripple and Litecoin. Gold and silver are also offered. The large variety of assets on one platform make it ideal for traders seeking to diversify their portfolio or find more opportunity in general. 

Should I sign up for PrimeXBT?

If you are interested in CFD trading, the low minimum deposit and customizable, easy to use platform is perfect for novices and professionals alike. Anyone is welcome to register for a free account.

How do I sign up for PrimeXBT?

To sign up for PrimeXBT, visit primexbt.com/register and follow the simple steps to get set up. After that make your first deposit, fund your account,and you will be ready to start trading CFDs right away.

Risk Disclaimer:

Investing in or trading gold or other metals can be risky and lead to a complete loss of capital. This guide should not be considered investment advice, and investing in gold CFDs is done at your own risk.

The information provided does not constitute, in any way, a solicitation or inducement to buy or sell cryptocurrencies, derivatives, foreign exchange products, CFDs, securities, and similar products. Comments and analysis reflect the views of different external and internal analysts at any given time and are subject to change at any time. Moreover, they can not constitute a commitment or guarantee on the part of PrimeXBT. The recipient acknowledges and agrees that by their very nature any investment in a financial instrument is of a random nature and therefore any such investment constitutes a risky investment for which the recipient is solely responsible. It is specified that the past performance of a financial product does not prejudge in any way their future performance. The foreign exchange market and derivatives such as CFDs (Contracts for Difference), Non-Deliverable Bitcoin Settled Products and Short-Term Bitcoin Settled Contracts involve a high degree of risk. They require a good level of financial knowledge and experience. PrimeXBT recommends the consultation of a financial professional who would have a perfect knowledge of the financial and patrimonial situation of the recipient of this message and would be able to verify that the financial products mentioned are adapted to the said situation and the financial objectives pursued.

Other news