Understanding on How CFD Trades Work Made Easy with An Example

Contracts for difference or CFDs are derivative trading instrument, which offer traders a chance to trade on price movements of different financial assets like commodity futures and equity indexes. CFDs help to wager on different trade markets without actually owning a contract based underlying asset. CFDs are regarded as best option for diversification in the foreign markets.

Why trade CFDs?

  • Traders can use leverage 100:1
  • Low capital needs
  • Large exposure with small cost on transaction spread
  • Earn from both markets – bullish and bearish
  • No commission charges
  • Easy entry and exit
  • Trade globally using a single platform

How does CFD trade process work?

Choose financial instrument

Select a broker’s platform that offers CFDs on myriads of individual markets like shares, indices, commodities, and currencies. Thus, you get instant exposure to worldwide markets including the US, UK, Asia, Australia, and Europe. All these options are good but you need to locate a suitable trading opportunity. Use research tools offered on trading platform and identify an instrument, which suits your trading style.

Choose to go long or short

After you chose the market, learn the current prices. CFD markets display 2 prices –

  1. Sell price or the bid
  2. Buy price or the offer

Difference between bid and offer is the ‘spread’. CFD price is based on underlying instrument’s price. If you speculate the price will increase then buy [go long] and vice versa.

Choose trade size

Determine the number of units to trade. One CFD unit value will vary on the basis of instrument you picked. CFD is leveraged product, so you will need a small percentage of overall trade value [called margin] to open a position. It means for large trade value more margin is needed. Use margin calculator available online to calculate initial margin.

Add stop & limit orders

Identify risk management strategy before you place a trade. Stop loss order is a good option, which helps to close trade automatically, if market attains a specific risk level. Set a price below current market level, which helps to minimize the losses. Limit order allows to close trade at price little higher than current market level, thus profit target gets locked.

Monitor trade

After placing stops and limits on trades, it is necessary to monitor open positions, so as to identify real-time updates of profit/loss. Market prices can be monitored on Smartphone using trading app.

Close the trade

If your trade does not get triggered automatically [stop loss/limit order] then you will need to do it manually by clicking ‘close position’ option. As soon as, you close the trade your net profit/loss will be displayed instantly and get reflected in your account balance.

CFD example

Let’s understand how to trade CFDs with example.

Currently Wall Street index is trading at 20509.0 /20510.6. The first is sell price and second is buy price.

Go long

You expect Wall Street Index equaling Dow Jones Price to rise, due to some changing tax reforms. Therefore, you plan to buy and open position with [go long] 5 CFDs at 0.5% margin requirement.

Margin required = [20510.6 x 5 shares] x 0.5% = $512.77

Winning trade

If Wall Street Index price rises 20555.0 /20556.6. It is a comfortable profit for you, so you decide to close the position and sell at 20555.0. It means you earned more than 45% profits on initial outlay.

Losing trade

If your speculation backfired and Wall Street Index prices collapse to 20455.0 /20456.6. Your CFD position is an open loss, so to cut losses you close the position at 20455.0. It means you lose $278 on 5 CFDs.

Holding cost

Because you hold a long position the finance will automatically get debited from you trading account each night as long as you hold the position.

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