CFDs and How to Use Them

The CFD instrument has become common in financial markets, which expands trading opportunities and allows you to speculate on price changes without owning an asset. For instance, you can make money by exchanging the EUR without having this currency in your account, or make a profit from the growth of Bitcoin without owning a crypto wallet.

A CFD is an agreement between a trader and a third party called a “contract for price difference.” To trade CFDs, you need to enter into an agreement with a broker (for instance, you can choose AvaTrade).

It should be noted that CFDs differ from investments in a number of ways. If you invest in any asset, then you usually hold it for a specific time frame; CFD contracts have no time limits, which means that you can keep positions for as long as your strategy requires.

It should be remembered that when investing, you need to pay stamp duty, and CFDs allow you not to do this. Lowering transaction fees allows you to earn revenue over a long distance, which is also an important factor. Interestingly, you can make money using CFDs not only on the rise but also on the fall in price.

For instance, you can predict the fall of the Turkish lira, Indian rupee, or other unstable currency to make a profit from it. Investing cannot provide such an opportunity. CFDs provide access to various markets: currencies, stocks, indices, crypto, commodities, and so on.

In this article, we try to answer the question “What are CFDs?” and tell you how to use this promising tool. Among other things, we consider such a concept as “leverage”, and also explain what risks you may encounter when trading CFDs.

Read also: What Is Online Trading?

Leverage, Margin, Spread, Overnight Fees

Let’s get acquainted with the basic definitions related to CFDs. In most cases, when trading CFDs, leverage is employed to increase possible income.

That is, a trader could control a larger position than they can secure with their capital. In other words, you pay only part of the bet, and your lender pays the rest. In this case, the funds are borrowed from the broker with whom you have agreed.

Leverage of 12:1 means that you can control a position of $1,200 with only $100.

The deposit margin is the amount of money that is used by a trader to open and manage a position. If we use the example above, then the margin in this case is $100. There is also the concept of “supporting margin.”

This is the amount of money that must remain in the trader’s account, otherwise, the broker will issue a margin call, which means that CFDs can be sold in favor of the lender. Some brokers (for instance, AvaTrade) offer high leverage (350:1 and above), but you should understand that in this case, you are not only claiming a high income but also putting your capital at risk.

It is clear that CFDs are bought and sold at different prices. This variation is called the spread. The broker is interested in having a spread, as this is their compensation for providing services. It often happens that it is not profitable to sell CFDs on a certain day, then the position is transferred to another day.

If you hold a CFD position overnight, the broker charges an additional commission (overnight fee), since most of the money in the contract belongs to them.

Hedging with CFDs

Imagine that you have a physical position on a real asset. You have the option to use a CFD to “hedge” this position. You can choose the opposite CFD position to compensate for the losses from the real position. This move is often used by experienced traders.

The fact is that you should insure yourself against unfavourable price movements, as your forecasts do not always come true and the market may not move in your favor. For instance, you have invested a large amount in Bitcoin and then you find out that a sharp drop in the price of cryptocurrencies is predicted due to cheaper graphics cards.

In this case, you can open a CFD to recoup some of your losses. When you buy CFDs hoping that the price will decrease, then you take a short position on the CFD. Interestingly, you can hedge CFD positions using the opposite position.

For instance, you have opened a long CFD position in EUR, but you have learned that the price of the European currency is expected to decline in the coming days, then you open a short CFD position to compensate for the losses.

CFDs Features and Conclusion

CFDs are better than futures and options because they can be extended for an additional fee. The choice of contract duration varies depending on which strategy the trader has chosen. If an asset has high volatility, then there is a high probability of a temporary decline.

For example, if you open a long CFD position on Bitcoin, then you will most likely have to renew the contract. We can summarise by saying that CFD is a convenient tool that allows a trader to increase their profits, but you always need to be aware of the possible risks and gradually improve your strategy to achieve better results.