The term CFD stands for Contract For Difference. This is a contract to exchange the difference in value of a financial instrument (the underlying market) between the time at which the contract is opened and the time it is closed.
SO WHAT IS CONTRACT FOR DIFFERENCE?
A contract for difference is a type of derivative which works by acting as an agreement to exchange the difference in value of an asset between the point at which the contract is opened and when it is closed.
The price at which a CFD is trading will always match the current market price of its underlying asset. If you wish to buy a share CFD of Apple, for instance, then your CFD will increase in value as Apple’s share price increases. If Apple’s share price decreases then your CFD loses value accordingly.
However, there are several differences between trading a CFD and traditional trading. Two key differences are the ability to go long and short, and leverage
LONG VS SHORT
With both long and short trades, profits and losses will be realised once the position is closed.
You don’t have to use a CFD to mimic a standard trade – you can also open a CFD position that will increase in value as the underlying market decreases in price. This is referred to as selling or going short, as opposed to buying or going long.
If you think Apple shares are going to fall in price, for example, you could sell a share CFD in the company. You’ll still exchange the difference in price between when your position is opened and when it is closed, but will earn a profit if the shares drop in price and a loss if they increase in price.
WHAT CAN YOU TRADE WITH A CFD?
CFD TRADING EXAMPLE
You can also use a CFD to get exposure to a much larger position than with a standard trade. Using leverage, you can agree to exchange the difference in price of a larger amount of an asset without having to commit to the full cost of the position at the outset.
Say you wanted to open a position equivalent to 500 Apple shares. With a standard trade, that would mean paying the full cost of the shares. With a CFD, you might have to only put up 5% of the cost.
You’ll still exchange the difference in price of 500 Apple shares from when your position is opened to when it is closed, so your profit and loss will still be calculated on the full size of your position. That means that profits can be hugely multiplied: but that your losses can as well, even above your original deposit.