CFD Trading Explained

CFD trading requires good preparation and, above all, a reputable broker. At the same time, every trader must know the special terminology, familiarize himself with it and also understand it. Therefore, some of the trading terminology is explained below and common questions on the subject are answered.

Which CFD trading terms do I need to know?

• Bid/Ask: A “Bid” is the price at which a currency is offered for sale. With an “Ask”, it is the rate at which a currency can be bought.
• Spread: The difference between the selling (“bid”) and buying (“ask”) rates is called the spread.
• Margin: A margin is the amount of capital required to open a position or to hold a position.
• Leverage: Leverage is the cost of borrowed capital to increase a potential return. This means a trader who trades with leverage has the opportunity to trade with amounts that are significantly higher than the capital that serves as margin. High leverage can significantly increase a return, but it can also increase potential losses as well.
• Interest: Interest is the price paid for short-term funds. That is, the amount paid for a loan or granted on a deposit.
• Long: A trader who speculates on rising prices expects a rising price when buying a CFD.
• Short: A trader speculating on falling prices expects a falling price when buying a CFD.
• Value date: The value date is the date on which a credit or debit takes effect. It denotes the date of settlement of a foreign exchange transaction.
• Trading and Pricing: CFDs are traded in units. These vary depending on the commodity being traded. Oil is traded in barrels; wheat is traded in bushels; coffee is traded in pounds. All trading units are set to a standard measure called a “lot” (= share).
• Lot: A lot is the size of a transaction. A lot represents the minimum quantity with which an instrument is traded. In CFD trading, the trade size varies from 1 to 500 units of the respective CFD.

How exactly does CFD trading work?

Investors who speculate with shares in order to thereby achieve short-term profits require capital. As a rule, however, profits are made here, which are rather insignificant. The investor buys in the classical trade a share thus actually. In contrast, when trading CFDs, he has nothing to do with the acquisition of the share. “Contracts for difference” or contracts for difference work on the principle of a lever and a security deposit.

Explanation with an example

The trader wants to buy a share for 100.000 Euro, because he thinks that this share has risen one Euro at the end of a trading day. The share value is 100.00 Euro, so the profit would be 1,000.00 Euro. However, the trader does not have the amount for the investment of 100,000.00 euros at his disposal, but only 500.00 euros, for example. The broker, with whom the trader keeps the trading account, has for the said share a leverage of 200. This leverage says that the trader must deposit as security for the trade, only 500.00 euros. 100,000 divided by 200. This is called the margin.

Rising price

If the price of this share rises as expected, until the end of the trading day by one euro per share, the trader can sell the right to the position with a profit of 1,000.00 euros. The profit accrues to the trader, minus a spread for the broker.

Falling price

However, if the price of the stock goes in the opposite direction, the trader may lose the margin, and in the worst case, lose it altogether. However, brokers have trading systems that automatically cancel a trade when the trade reaches a certain level of loss.

What are the risks of CFD trading?

Both the trader and the bank are entitled to compensation for the difference in the price of the underlying asset. The price of the underlying asset at the time of opening the CFD position by concluding the contract and the price at the time of closing the CFD position are decisive for this. If the trader’s expectation does not occur, he owes the difference between the price at the opening of the underlying and the price at the closing multiplied by the number of units of the underlying at the closing of the CFD position.

The amount of the loss cannot be determined from the beginning.

The loss may even exceed the trader’s original stake in the form of the balance on the CFD account. The trader is obliged to compensate the loss, which may exceed his balance on the CFD account. Therefore, the trader’s risk of loss is not limited to the original capital investment in the form of the balance on the CFD account, but may include the entire assets of the customer. In the event of a loss, the bank will close out the CFD account if there are insufficient funds in the CFD account in its own interest. The customer cannot derive any rights from this.

CFDs with currencies

CFDs with currencies as underlying are called Forex-DFDs or simply Forex. The term “Forex” comes from “for” (foreign) and “ex” (exchange). Forex trading refers to international foreign exchange trading. It involves buying and selling currencies. Due to the particularly high risks, special knowledge, skills and experience are required of the trader. Therefore, they are not suitable for most investors. The trader should check whether trading with foreign exchange suits his experience, investment goals, personal circumstances and financial possibilities.

High price fluctuations

Forex trading is characterized by very high price fluctuations in a short period of time, often within a day. It is true that this reduces the capital investment, so that a high trading volume can be moved with a small investment. However, even small price fluctuations have a very large impact on the capital invested.

What is trading with leverage?

CFD Trading PlatformCrucial advantage of CFD trading is investing with leverage. This makes it possible to open a position without having to provide the total value of the position. The capital is not tied up in one transaction, but it can be used for further investments.

Explained with an example

For example, a trader buys CFDs worth 10,000 shares. If the minimum margin is 5% of the value of the shares, he only has to deposit 5% of the total value of this position as collateral. For example, if the share price is 1.50 euros, the value of the shares is 15,000 euros for 10,000 shares. For CFDs with a margin of 5%, only 750.00 euros must be deposited here. The trader can therefore increase his profit considerably when investing with leverage. However, he should know that he can also achieve a loss in a corresponding amount. Consequently, high volumes can be moved with a small capital investment. The trader can trade with appropriate levers, for which he only needs to deposit a security deposit (margin).

As a rule, a margin of 5 percent is specified.

However, there is also the possibility that the margin can be set by the trader himself. Trading CFDs is a margin business, whereby capital can be used highly efficiently. With a margin of 5 percent the customer with 1000.00 euro can trade the basic value with an equivalent of 20,000.00 euro (5 percent of 20,000 euro = 1,000 euro). So he trades with “only” 1.000,00 Euro a value of 20.000,00 Euro. The corresponding leverage is 20 (1,000.00 Euro x 20 = 20,000.00 Euro).

• For example, the trader can reduce the leverage from 20 to 10. His margin is now 10 percent. If he wants to move a value of 20,000.00 euros, he must now deposit 2,000.00 euros as collateral.
• Thereby profit or loss remain nominally always the same, independently of how high the leverage or the margin is.
  The trader can achieve disproportionate profits with CFDs.
• He can fully exploit the potential of CFDs by means of leverage. Another advantage is that CFDs can also be used to speculate on falling prices. With CFDs, the trader can speculate on all kinds of assets worldwide, such as stocks, commodities, currencies and indices.

However, CFDs are very speculative

Due to the high leverage, high losses can also occur. CFDs are not listed on the stock exchange. They are usually traded over-the-counter through a CFD broker. In this type of trading, the CFD broker usually provides the prices.

What types of orders are there?

The trader has different possibilities to trade CFDs. A distinction is made between basic orders and order types for position hedging.

Stop Loss: A stop loss order is linked to an existing order. The trader achieves through this order that losses of open trading positions can be limited. A stop-loss order can be slightly below or above the price at the time of purchase of the CFD, i.e. the cost price.

Trailing Stop Loss Order: A trailing stop loss order is a dynamic stop. Here the trader has the possibility, depending on the price development, to tighten his stop order by an amount determined by him to the current price. In the case of a long position, the stop order is tightened when a new high is reached. In case of a short position, the stop order is tightened when a new low is reached. In this way, the trader can let profits run. The hedge automatically adjusts to rising or falling prices, so that the right time to exit for a profit realization is not missed.

A limit order is also used to hedge a position. This is a limit order to realize a profit. (Take Profit Order). A hedge order can be placed immediately when the basic order is placed, i.e. when the position is opened. The trader can enter the hedging order either as a concrete limit, i.e. the distance between the buy price of the order and the expected profit, or as a maximum profit (take profit order).

• In an If-Done order, the trader links two orders for one instrument. A second order is activated only after a first order is executed.
• OCO order: A One-Cancels-Other order consists of two orders. Once one of the two orders has already been executed, the other order is automatically deleted.
• If the trader places a stop loss order and a take profit order at the same time as his base order, then he has placed an If Done OCO order. An execution of the basic order (If Done) activates the two If Done orders (OCO). If one of the two orders is executed, the other order is automatically cancelled.
• With the different order variants Trailing-Stop-Loss-, OCO- and If-Done-Order the trader has the possibility to implement his trading strategies automatically. He gets support for an optimal implementation of his trading strategy.

What is a margin call?

CFD TradingIn CFD trading, a “margin” is to be provided as a kind of security deposit, which is based on the underlying asset. If the price development goes against the trader’s expectations (i.e.: falling prices for long trading positions or rising prices for short trading positions), there is a possibility that the capital provided by the trader is no longer sufficient to meet his margin obligations. The trader’s existing capital may therefore also include unrealized profits and losses, which may be available as capital for opening any new positions. Unrealized profits are added to the trader’s CFD account, but cannot be paid out, which is why the broker’s trading platform also shows “capital available for payouts”. However, a payout of realized profits can be made on the following day after the official settlement.

The trader always has his entire capital at risk and not just the margin. In case of losses due to extreme market conditions, there is even a risk of the trader having to make additional margin payments. He can lose more capital than the margin used for a position.

Most brokers offer a risk limit when managing the account. Here, the trader can deposit a margin of 20 percent for all instruments. An additional risk limit can be set up by having the trader trade with a uniform leverage of five and no margin call. In contrast, accounts without risk limitation can trade with levers of up to 100. However, there is a margin call obligation if the closing of a position is too late.

If the trader receives a margin call, he can either close the trading positions or deposit money into his CFD account. In doing so, the trader must keep in mind that a deposit of additional capital can take a few days.

How can I manage risk when trading CFDs?

As a rule, the risk of losing money trading CFDs can not be excluded. However, investors have ways to limit the risk. The simplest and most effective way is to use stop prices.

Different order types

Most CFD providers provide different order types. For example, a stop-loss order ensures that a CFD position is automatically liquidated as soon as the underlying asset, such as a share, reaches a certain price. Only with an order with a guaranteed stop price can the customer be sure that the position will be sold at exactly this price. A stop-loss order should therefore be set for each new CFD position to limit losses. Where the stop is set here depends, among other things, on the fluctuation range (volatility) of the underlying. Likewise, the impact on the overall portfolio must be considered.

Trading platforms

Each provider for CFD trading provides special trading platforms. Traders can buy and sell CFDs conveniently. Either traders need to install software or trading can be done via the PC’s web browser. It is also possible to trade using smartphones or tablet PCs.

Big differences in trading platforms

However, there are big differences in performance and operation of the trading platforms. The customer should therefore ask himself whether sufficient tools, such as chart analyses, are available to him. It is generally recommended to start CFD trading with a demo account. There, the investor can get to know and try out leverage effects with “play money”.

Free training courses

Almost all CFD providers offer seminars on site or on the Internet (webinars). These are usually free of charge and always without obligation. Here a beginner can learn the basics of trading CFDs and identify typical mistakes. At the same time, he can ask questions.

What are the strategies for CFD trading?

Who wants to learn CFD trading, should start with very simple strategies. Who buys shares as an investment, should in any case first familiarize themselves with the fundamental data. How high are the profits? What are the future prospects of the company? However, CFD trading is all about short-term decisions and not longer-term analysis.

When forecasting contracts, chart analysis is absolutely necessary

The graphical representation of price trends is the best way to identify trends. Some brokers offer chart analysis on their trading platforms. This includes averages as well as marking highs and lows.

Trend following

In the trend following strategy, the trader speculates on the continuation of a trend. The probability that a trend will continue is usually higher than the probability that a trend will reverse. Since many traders use this trend following strategy, this in a sense reinforces or keeps the trend alive. The easiest way to do this is to look at moving averages, such as for 30 or 90 days. The result of this trend is a line that represents the average of the past few days. Through this line, swings downward or upward are balanced. If the line tends to go up, the trader should bet on rising prices. If the line points downwards, he bets on falling prices.

Averages

It is also possible to combine two averages with different lengths. If the short-term average intersects the longer-term average from below, this indicates a rising price. If the short-term average intersects the longer average from above, this indicates a falling price. For example, a seven-day average can be combined with a thirty-day average. If the seven-day average is lower than the thirty-day average and intersects it from the bottom up, this means that the average price of the last seven days is above the thirty-day average. This is then a signal for rising prices.

Connect lows

Low points can also be connected in a chart. This makes it possible to see at which prices a change in direction becomes visible. Several lows can be connected with a line. If the resulting trend line points upwards, this indicates rising prices, if it goes downwards, further falling prices are to be expected.

However, it should be noted that developments also do not always go in only one direction. If a trend following strategy runs into an overbought or oversold market, this strategy can then also no longer work. In this case, prices should be secured by setting a stop loss.

Trend reversal

The trader can also recognize certain buy signals by means of a trend reversal. However, a trend reversal is less likely than a trend following. If there are signs of a trend continuation, but also of a trend reversal, the trader should rather bet on a continuation of the trend. However, if a trend line that is directed upwards is basically broken downwards, this may indicate the beginning of a possible downward trend.

How does the trader find the right broker?

To trade CFDs, the customer must open a trading account with a broker. There are a large number of trading houses. This makes a CFD broker comparison essential. In Europe alone, over one hundred different brokers offer their services. This requires some detailed knowledge to recognize the quality behind the advertising promises of the providers. Do not be lured!

Often, beginners who gain experience with CFD trading for the first time are convinced by false arguments of the brokers. This includes exaggerated leverage, such as 400 : 1 and more.

What criteria make a good broker?

Important are the environment of the broker, the market model and the trading platform. Of great importance are the technical precautions against losses and especially the protection of the customer’s account balance in the first place. The broker’s registered office and regulation should be in an established financial location

A good broker has a multi-channel trading platform. This should be web-based and can be operated from any PC. Likewise, mobile trading with smartphone or tablet should be possible. Good brokers have a wide range of tradable underlying assets, such as stocks, commodities, indices or currencies. A qualified broker for CFDs should also take a look at the imprint.

Here it should be explored in which country the broker is based. A clear plus point is if the broker has its headquarters in Great Britain or Switzerland. Brokerage houses that are based in tax havens with lower regulations should be avoided. However, most brokers are based in England or Cyprus. Basically, the location of a broker says nothing about its quality. For example, training opportunities can be an indication that it is worthwhile to open an account with just this broker.

What are pips?

• In foreign exchange trading, profits or losses are expressed in “pip”. The term “pip” stands for “percentage in point”.
• Thus, a pip is the smallest price representation in a currency pair. It is the fourth digit after the decimal point. So the 1/10,000th (0.0001.) part of the currency. For pairs related to the Japanese yen, a pip refers to a 1/100th (0.02.) part of the currency.
• Profits from a foreign exchange trade are expressed in pips. Assuming that the trader buys EUR/USD at a forex rate of 1.5036 and sells EUR/USD at a rate of 1.5016, he has made a profit of 20 pips (1.5036 – 1.5016 = 20).
• The pip value is either variable or fixed. It depends on the currency pair to which the value refers.

At what times are CFDs traded?

Trading CFDsCFDs are traded at the same times as the underlying assets. For equities, the times of the respective cash markets apply. For underlyings traded on cash markets and futures markets (such as indexes), the trading hours of the futures markets (Eurex) apply. Cash transactions are concluded in the cash market segment. Order executions are made within a very short period of time. Transactions beyond the cash market are allocated to the derivatives market (futures market).

The futures markets are concerned with commodity futures transactions in many different areas. The transactions concluded here are to be fulfilled by both contracting parties within fixed agreed periods. The price of the underlying asset to which the contract in the futures market refers is fixed when the contract is concluded. It is then valid regardless of price developments that may occur during the term of the forward contract.