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What Is CFD Trading? Case Study Included

by CFD Guru Team   ·   

What is CFD trading

With the rise of modern technologies, people think of new ways to earn money without leaving home. Most of the time, the ways people seek include flexibility of one’s daily schedule and possibility to generate more income than an average corporate job offers. CFD trading can be one of the most lucrative careers nowadays if you do it properly. It is possible to be successful and earn a good living trading only a few hours per day, but just like starting any other career, there is a lot to learn before even opening a trading account.

What is CFD

The abbreviation CFD stands for “Contract for Difference” and represents a contract between two parties – “buyer” and “seller” and replicates the index or commodity on which it is based. The CFD owner has all the benefits of owning a physical stock without actually owning it.

Trading CFD doesn’t mean buying or selling the underlying assets, such as physical shares, currency pairs or commodities. What you are buying in case of CFD trading is a contract between yourself and the CFD provider. When you trade CFDs, you buy or sell a number of units for a particular instrument depending on whether you think prices will go up or down. This enables you to leverage not only by rising but also by falling markets as well.

After purchasing the CFD, the buyer gains all the financial rights that are associated with owning the stock, such as dividends, price movement, stock splits, etc. However, this doesn’t give a CFD buyer the voting rights, unlike a physical shareholder. In order to compensate for the benefits, the buyer pays the seller a financing cost that includes the overnight interest rate on the speculative value of the position.

Basically, it’s a swap of cash flows between the buyer and seller. As CFD is just a contract and isn’t a deliverable, it has no expiry date as well.

So, you might be wondering, if it’s not an actual stock, then what’s the point of owning and trading CFDs in general. The point is, that these contracts demand the seller to pay the difference between the current value of an asset and its value at contract time to the buyer. The difference is either a profit or a loss, therefore, a CFD is a derivative instrument repeating the underlying instrument from which it is derived.

In case the difference between the current value of an asset and its value at contract time is negative, the buyer has to pay instead of the seller. CFD trading enables you to speculate on the rising or falling prices of fast-moving global financial markets (or instruments) such as shares, indices, commodities, currencies, and treasuries.

How CFD trading works

A network of brokers organize the market demand and supply for CFDs and make prices accordingly. The CFD is a trade-able contract between a client and the broker, who are exchanging the difference in the initial price of the trade and its value when the trade is unwound or reversed. In other words, CFDs are not traded on major exchanges such as the New York Stock Exchange (NYSE).

A day trader’s job is to find a repeating pattern (or that repeats enough to make a profit) and then exploit it. Essentially, CFDs are used by day traders to make price bets as to whether the price of the underlying asset or security will rise or fall.

Read More Day Trading Related Articles.

To make things more clear, imagine you’re a day trader, who observes the statistics of financial assets. Based on the trends you see, you develop your own expectations on whether the price of that asset will go up or down. You buy the CFD when you expect an upward movement in price and you sell an opening position when you see the downward movement.

So as we have seen above, CFD traders gain access to the specific stock movement and have the ability to speculate on its price no matter the price will rise or fall.

Let’s discuss a classic case of CFD trading to better illustrate its point and how it works. For example, if a client wants to buy 1,000 shares in Apple at $30, he directly contacts his local broker and orders him to buy 1,000 shares in the underlying cash market. The client also has another choice, to contact a CFD provider and buy 1,000 CFDs on Apple at the same or similar price of $30. CFD will move in line with the commodity from which it is derived and will settle each day at the same settlement price. So let’s say Apple stock moved to settle the day at $30.50, the CFD will be marked to market at $30.50 and the buyer will be marked to market credited $0.50 on the 1,000 Apple CFDs by the CFD provider, that amounts $500.

CFD users pay initial margins and mark to market overnight payments daily, that reflect the daily profit or loss movements and a set percentage of the CFD notional value. This initial margin also protects the CFD clients from most unfavorable price movements until the next mark to market margin call is made.

CFD brokerage models

Trading institutions collect their service fees in two major formats: “brokerage” and “no brokerage” models. Let’s review each one of them shortly to get an idea of what to expect from each type.

“Brokerage” model

“Brokerage” model offers CFDs at exactly the same price and liquidity as the underlying cash market and a brokerage is charged on all transactions. As soon as the client makes a CFD order, CFD provider immediately replicates these orders into equivalent cash orders on the underlying cash market. Likewise, any client trades are also immediately replicated onto the cash market. All CFD moves are counterbalanced by the movement in the underlying cash market. Therefore, if the CFD provider buys a CFD position in a particular stock to their clients, then the provider sells the exact equivalent position as well. If the stock price rises, the profits made on the high CFD position will balance the loss made in the underlying stock position which the CFD provider sold for this exact reason. And on the contrary, if the stock price falls, the gains made by sold underlying position will balance the CFD losses.

“No brokerage” model

Nowadays, most of the brokerage companies use “no brokerage” model. By the terms of this model, the CFD provider adds a slight spread on the CFD price over the underlying cash market. The amount of this spread usually reflects the amount the CFD provider would charge the clients in terms of “brokerage” model. However, “no brokerage” provider is more flexible in hedging methods and use more advanced array of products and methodologies, that range from a combination of cash, futures, and options to manage their exposure. The “no brokerage” provider always tries to reduce the amount of hedging in order to increase returns by netting all their positions into one single portfolio and hedging the exposure to the main portfolio.

Please note that traders don’t have the ability to post prices directly to other CFD traders in a CFD marketplace, therefore neither of these models give the CFD clients (trader) ability to trade between each other. Additionally, no CFD orders are anonymous and they aren’t protected by clearing model conducted by a centralized market Clearing House.

All contracts and transactions are bilateral between the client and the CFD provider and in order to reverse and close their positions, clients are usually required to transact back through the same institution they used to transact their funds in the beginning.

Check Out Our Broker Reviews!

What makes a good CFD broker?

So you might be wondering now, what are some of the qualities a good CFD broker should have? Well, first of all, they should have fair fees.

Secondly, a good CFD broker should offer a lot of CFD options. They should have a great platform, meaning it must be intuitive – easy to open an account and deposit. Most of the brokers nowadays offer demo accounts, where you can use the virtual funds to practice trading at the beginning of your new lucrative career.

And now, let’s see the list of top 5 best CFD brokers in 2019 and review some of their details. All five brokers are regulated, so you can freely pick your favorite one based on your personal needs, requirements, and preferences.

The top 5 best CFD brokers in 2019

eToro

eToro is one of the best social trading platforms offering multi-asset trading with a primary focus on CFDs and is recommended for traders as well as anyone interested in social trading. Its intuitive social trading platform gives you an opportunity to view and copy other traders’ trading strategies.

eToro is considered safe because it’s a well-known fintech company and its UK arm is regulated by a top tier regulator.

Plus500

Plus500 is on the top 5 trading platform list because of its good trading fees and a great mobile platform.

As Plus500 is listed on a stock exchange, discloses its financials and is regulated by top-tier regulators around the world including in the U.K, Europe, Australia & South Africa, it is considered as one of the safest trading platforms.

Read Our Plus500 Broker Review.

AvaTrade

AvaTrade was one of the first forex brokers who offered CFD trading on commodities, indices, and stocks. This broker is recommended as it offers to trade on the best trading platform – MetaTrader 4 – with full mobile trading support.

AvaTrade is a licensed regulated broker in the EU, Australia, British Virgin Islands, Japan, and South Africa.

Axitrader

AxiTrader is recommended because of its tight spreads and fast execution. It also offers access to the world’s most popular and most reliable trading platforms – MetaTrader 4 – where you can trade a wide range of Forex, Commodities, and Indices.

Axitrader is especially popular among Australian traders.