How to trade CFDs
An introduction to CFD trading including how it works and how to trade CFDs with margin and leverage.
What are CFDs?
CFDs, also known as Contract for Difference, describe any financial contract that is settled in cash form rather than through the delivery of the underlying assets which the contract covers.
CFDs were initially used in exchange-traded futures on both stock indices and interest rate contracts. It suited these instruments because many of those involved in financial futures either did not need, want to make or receive delivery of the underlying instruments they were trading. For example, a fund manager hedging a position in UK equities via an index future could be happy to pay or receive cash rather than physical shares at the end of the contract. In that way, the Fund manager enjoyed the economic benefits of hedging, i.e., the rise and fall of the price of the index future without the hassle of having to trade and monitor a 100 individual shares.
How do CFDs Work?
This innovation might seem complicated but it’s a relatively straightforward idea to implement. In any given trade, the buyer or seller pays the other party (through an exchange or clearing house) the cash difference between the open and closing values. The direction of payment is based on that trade’s P&L.
If you were long, that is you had bought a contract, and the price of the contract rose above the entry price, you would have a running profit. If you sell out of that contract, you would receive the cash differential between the opening and closing prices.
It follows then that if you bought an index contract and the price moved against you and fell below your opening level, then you would incur a running loss. Should you close the position at this time, you would realise your loss and owe the counterparty or another side of the trade the cash difference between the opening and closing prices of your trade. In both cases, the cash differences would be multiplied by the number of contracts or lots traded be that 1, 10 or another number, to establish the final value or payment due.
It was soon realised that the CFD concept was applicable to a wide range of instruments such as Gold, Oil and Forex. In fact, it’s applicable to any instrument where participants wish to trade the rise and fall of the underlying price without the inconvenience of physical delivery.
CFDs really came into their own in the late 1990s when the concept was taken off-exchange to the Over The Counter or OTC market. That move coincided with the birth of online retail trading, as the internet was delivered to our homes and offices.
It was a match made in heaven. Brokerages became the counterparties to CFD trades, offering their client access to a wide range of instruments to trade long or short with equal ease.
Trading CFDs with Margin and Leverage
CFD trading can be leveraged or traded on margin. That is, a trader’s deposit is magnified or geared by their broker. It allows them to control a larger amount of an underlying instrument than an unlevered deposit would allow. As you might expect, the popularity of CFDs soared because of this and by the midpoint of the first decade of the new millennium, it was said that 50% of the daily turnover of the London Stock Exchange was driven by CFD trading activity. Brokers also charged clients interest for the provision of leverage but only if their positions were held overnight. Day traders paid no financing charges, and that convention still holds true today.
An Even Footing
The combination of long/short leveraged trading driven by online direct market access not only brought the dealing room into people homes and offices, it started to level the playing field.
Trades and strategies which had previously been the preserve of Hedge Funds and a few high net worth individuals became available to all traders. The ability to sell short (selling something you don't own in the hopes of buying it back at a later point, at a lower price). Without having to worry about making delivery by a specified date, opened up a whole new avenue of trading to tens of thousands of retail traders. Using CFDs traders could take positions across different asset classes and take view of their relative performance. Of course, access to these trading opportunities meant a steep a learning curve for retail clients, who had to build up their knowledge and understanding of these products and trades. But then as I often say every day in the markets can be learning curve for us all.
Pepperstone clients get access to our cutting-edge trading platforms and technology, which come equipped with charting packages and analysis tools to aid them in CFD trading - all of this provided at no charge. If you haven't used CFDs before, you can explore the world of CFD trading, without risk to your capital, through the use of our demo accounts. This is a great way to become familiar with both the markets and their movements and the functionality of our trading platforms.
For more information on the CFD instruments offered by Pepperstone, click"here.