A CFD is also known as a contract for difference. It is a derivative product with an underlying asset as its basis. CFDs enable you to trade on the price movement of underlying financial assets (such as indices, shares, cryptocurrencies and commodities).
A CFD functions as an agreement to exchange the difference in the value of an asset from the time the contract is opened until the time at which it’s closed. It is important to note that with a CFD you never actually own the asset or instrument you have chosen to trade, but you can still benefit if the market moves in your favour, or make a loss should the market move against you.
In this way, a CFD allows you to trade nearly every underlying asset including those which are considered “rare” or nearly impossible to trade. An index, for example, contains a large number of different stocks, which would normally require a very large capital outlay to own. CFDs offer you the opportunity to speculate on the price of such an index without having to invest a large amount of capital. Instead, you choose exactly how much you would like to invest and your profits or losses are also relative to the volume of your position.
Once you close your position, the profit or loss is calculated by determining the difference in position opening and closing price of the underlying asset. The more the underlying asset moves in your anticipated direction, the more you can profit and vice versa.
How does it work?
A CFD is a leveraged product, which means you only pay a margin (collateral), which corresponds to a fraction of the actual position value. Using leverage also means that you only need to deposit a small percentage of the full value of the trade in order to open a position. This is called ‘trading on margin’. While trading on margin allows you to magnify your returns, losses will also be magnified as they are based on the full value of the position.
Leverage essentially enables you to reap the profits or suffer of trading with larger volumes with little capital outlay. This also implies that small price movements can create high profits as well as high losses.
Placing a CFD Position
Before opening a CFD position, you first need to decide if you want to invest in rising or falling prices for the underlying asset. Once you open a CFD position, the price change will be determined. At closing the difference between the price at the opening of the position and the price at the closing of the position will be calculated.
The difference multiplied by your traded volume determines your profit or loss, depending on if it has been set for falling or rising. It is also important to note that unless you are trading a futures contract on certain commodities, CFDs have no expiration time.
Lots and Pips
A CFD is always calculated in contract sizes. This contract size illustrates the extent to which an asset is traded. A standard contract also referred to as a Lot, for the EUR/USD currency pair is equivalent to a volume of $100,000. The next important step is to know the value of a Pip. A Pip is the smallest accountable value of the underlying asset. For the EUR/USD currency pair a Pip has an value of 0.0001.
Profit and Loss
The exact profit or loss is dependent on both the price and the contract size. Whenever you trade a CFD you are dealing with high volumes, which are calculated according to this formula:
Bid/Ask price * Contract size * Number of contracts
Let’s assume for example that you want to open a position on a falling EUR/USD price with one standard lot, this would mean the following position value: $1.09715 * $100,000 * 1 = $109,715. In order to open any position, you must have a certain balance in your trading account. When opening a position a security deposit will be deducted from your account balance, this is the so-called Margin.
For the EUR/USD position it is calculated with 1% of the position value. This means for the example above, you would need to have a security deposit of $1,097.15; this amount must be available in your trading account.
In case of win
Assuming that the market moves in the way that you anticipated. The EUR/USD price falls to a new level of $1.09153/$1.09161. You opened a position on a falling price, meaning you had to sell the EUR/USD first and buy it back now to close the position. Therefore, for you, the asking price of $1.09161 is important. With a CFD the difference between the positions is used for the pay-out. Meaning that your position for this price has a current value of: $1.09161 * $100,000 * 1 = $109,161
Since you seemingly have opened a position on a falling exchange rate, the calculation of your profits would be as follows: Entry price – Exit price = Profit = $109,715 – $109,161 = $554
Upon closing this position, $544.00 will be credited to your account. In addition, your initial security deposit (Margin) $1,097.15 will also be made available again.
In case of loss
In this case scenario, the market moves counter to what you predicted. The EUR/USD exchange rate rises to a new level of $1.10248/$1.10256. Again here the asking price is important. The asking price is now $1.10256 giving your position a value of: 1.10256 * $100,000 * 1 = $110,256
Your loss would be calculated using the following formula: Entry price – Exit price = Loss = $109.715 – $110.256 = -$541
Keep in mind that since you had already set aside a security deposit of $1,097.15 from which your loss on this position would be deducted so the difference of $556.15 would then be returned to your account.