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How Does CFD Trading Work?

CFD (Contract For Difference) is a contract for the difference in prices. The sale or purchase of a financial instrument by CFD does not imply the documentary registration of rights to it (i.e., of course, you have the right to the concluded contract, but you do not have the rights to the subject of this contract). CFD trading is a very interesting instrument that attracts numerous traders.

That is, if you, for example, entered into a CFD contract for the purchase of 1,000 Microsoft shares, you will not become their owner, and these shares will not be transferred to you. Why, then, make such a deal?

In fact, everything is very simple — the transaction is made only to get the price difference. And this, in turn, is done either for hedging or speculative purposes. If you are not a long-term investor and your goal is only to make more money in a limited period by buying at a lower price and selling at a higher price, then why do you need to register your shares?

After all, it is much easier to buy a couple of CFD contracts on some shares in the hope of an increase in the price, and when the price grows up, close them with a profit that constitutes the difference in the closing and opening prices minus a small broker's commission. That

being said, note that you do not have to spend money on inclusion in the register of shareholders and other exchange fees for access to the market.

Contracts for differences appeared relatively recently, in the 90s of the last century. Initially, they were focused exclusively on stocks, but now their underlying asset can be stock indices, currency pairs, cryptocurrencies, and other basic financial instruments.

CFD is a good possibility to earn some money. First, you need to learn more about Forex trading to know to forecast the stocks. It is available for people from all over the world, from Japan to America, to England, to South Africa.

A simple example of CFD trading

Here's a simple example of CFD trading. Suppose a trader expects a fall in the London Exchange index against the background of the introduction of new sanctions against a number of the largest enterprises included in it. Then they open a short position, that is, conclude a contract for the difference in the direction of lowering the price of this stock index.

At the same time, they use a leverage of 1 to 100, which, if their forecast is justified, will allow them to increase their profit by 100 times. And to open a position, they will need a relatively insignificant amount of money (one hundred times less than what they would have given trading without using leverage).

In fact, during the last years, the popularity of CFDs only increased. Even more traders are interested in this possibility and try to achieve success. At the same time, the stock index, of course, did not fall but increased in price, bringing traders a profit in the amount of a hundred times higher than that which they would have had trading without using leverage.

If the trader urgently closes the unprofitable position (either in the manual mode or, more correctly, in the automatic mode — according to a predetermined Stop Loss order). Technically, a short position is closed by opening a long position in the same financial instrument and the same volume. That is, having initially sold the CFD, now, to close the position and exit the market, the trader must redeem it.

Advantages and disadvantages of CFD contracts

Actually, CFD contracts were created to simplify as much as possible the work associated with buy-sell procedures. More precisely, they were created for hedging shares on the London Stock Exchange, but they were best suited for speculative trading. Indeed, in addition to the above-mentioned issues, they have many significant advantages, such as:

       Low level of entry deposit for trading;

       The ability to use large leverage (up to 1:100). By the way, large leverage can also be a disadvantage — it is a double-edged sword;

       By closing CFDs on the purchase of shares, you are entitled to receive dividends on them;

       Wide opportunities for portfolio diversification are especially relevant for traders with a limited budget;

       Numerous financial instruments for which you can buy CFDs (from stocks to corn).

The main disadvantage of CFDs is the relatively large risks associated with the use of leverage which is typical for any margin trading in principle.

How do CFD contacts work?

       The trader chooses an asset for which a CFD contract can be made with a broker. It can be a stock, index, currency, or any other asset that a particular broker works with.

       The trader opens a position and sets the parameters of the transaction (long/short position, leverage, invested amount, and other parameters depending on the specific broker).

       The trader and the broker enter into a contract, agreeing on the opening price and possible commissions (for example, for postponing a position to the next business day).

       The position remains open until the trader decides to close it or until it is automatically closed. Automatic closing can occur as a result of triggering a stop loss or take profit order, or if the contract expires.

       If the position is closed in positive territory, the broker pays the difference in the price of the asset to the trader. If the position is closed in the red, then the broker gets the difference.

To learn more about how CFD contracts work, read the Forextime blog and find any useful information you need.

 



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