A CFD or “Contract For Difference” is a contractual agreement between a buyer and a seller concerning changes in the price of an asset. In CFD trading, as the price of the asset varies from the price stated in the contract, the buyer or the seller of the CFD makes a profit or a loss accordingly. If the price goes up, the buyer profits and the seller loses, and vice versa. The asset itself may be a currency, a commodity, a company stock or even a sector or a global index. However, there is no transfer of the asset. In other words, buying a CFD does not mean taking ownership of the underlying asset.
Where do CFD’s come from?
CFD trading was invented in the 1990s. One of the reasons for its creation was to avoid the tax that was due when real assets changed hands. Traders in exchanges in countries like the United Kingdom were then able to speculate on shares and avoid taxes that were at times, as high as 1% of the share transaction itself – and therefore a correspondingly greater part of any profit that was made. After first being used by institutional investors and hedge funds, they made their way into brokers’ offerings for private investors a few years later. Most countries now allow CFD’s to be traded, although the United States does not. There are still no standard contracts for trading in CFDs. Terms and conditions will depend on the particular broker you use, although brokers’ offers tend to be similar.
What justifies CFD trading?
Apart from tax considerations that may vary from one country to another, CFD trading may also be used for other reasons such as hedging or disguising a position. Investors who have acquired an asset such as a block of currency or options to buy shares can also use CFD’s to protect their positions. Others who want to acquire controlling stakes in the shares of a company for example can buy CFD’s through a broker. The broker will then buy the shares to hedge against the CFD’s that have been bought. When the moment is right, the investor can then convert the CFD’s into the real shares (so now a transfer of ownership of the asset is deliberately being made) and possibly proceed to a takeover bid for the company concerned.
Basics for trading CFD’s
CFD trading uses many of the techniques and tools that are already part of other financial activities such as forex trading. Fundamental analysis and technical analysis are both important tools for understanding the market and how the prices of different assets are likely to change. The same leading and lagging indicators that you would use for currency trading, for example, moving averages, oscillators and momentum indicators, also apply directly to CFD trading. Trading plans and strategies should be defined and applied in the same way to maximize the chances of making a profit, and to minimize the risk of trading loss that might otherwise be caused by emotionally driven decisions. Leverage, also an essential part of CFD trading, needs to be correctly understood and applied, as in forex trading. Overnight interest payments, whether negative or positive, must also be taken into account. CFDs make this aspect simpler in that interest is paid by an investor who buys CFDs (going “long”) and is gained by an investor who sells CFDs (going “short”).
CFD differences to options and futures
This indefinite roll-over feature distinguishes CFD trading from other financial products such as options and futures. Options expire and become worthless after a certain defined date, although there is no transfer of the underlying asset unless the buyer of the option chooses. Futures contracts are for a fixed length of time, but they then oblige the seller of the futures contract to transfer the asset to the buyer, who is obliged to buy it at the price initially specified in the futures contract. On the other hand when you buy a CFD you can terminate it at any time.
Accounting for CFD trading
Trading in CFDs means that your investor account will be constantly assessed for its “equity”: the total amount of money at any time as a function of money you have deposited or taken out, profits or losses you have made and the size of CFD trades that you have open. The equity or net balance of your account is affected by the current value of these trades. If the equity of your account falls below the margin needed to cover existing trades, the broker will make a margin call for you to deposit more money and close your CFD trades if no further deposit is made. Successful CFD trading is also a matter of keeping tabs on your account equity and avoiding situations where CFD trades are closed or cannot be started when you would have preferred to have such trades open.
Leverage for CFDs with ForexBrokerInc
our initial Account leverage is what leverage we grant you to trade Gold, Silver and Oil with. For all other CFDs the leverage equals to 25% of the initial Account leverage.For example, if the initial Account leverage on your trading account is set to 1:200 and you wish to trade Corn, then the leverage for Corn will be 1:50.