CFD trading, or Contract for Difference, is a way to speculate on the price movement of various assets, including stocks, indices, commodities and currencies. CFDs are a type of derivative product – meaning that their value is derived from the price movement of an underlying asset. There is more of an explanation about this here.
When trading CFDs, there are two ways to make a profit – the first is to go long, which is when you buy a contract and hope that the price will rise to sell it at a higher price and make a profit. The other way is to go short, which is when you sell a contract speculating that the price will fall so that you can repurchase it at a lower price and make a profit.
How Does Going Long Work?
Going long involves buying a CFD using margin. You must put up the total amount of the trade, called the notional value, but you can control a much more prominent position. Your profit or loss is determined by changes in the underlying asset’s value. In other words, if an investor goes long on GOOG stock via a contract for difference and GOOG rises from $800 to $900, then they make money because they purchased at a lower price and sold it higher – a classic example of going long.
How Does Going Short Work?
When shorting, people will borrow their broker’s shares to sell them immediately – basically acting as a market maker. If this causes the share price to fall, the short-seller can cover their position by repurchasing the shares at a lower price, thus making a profit. If the share price rises, the short-seller would have to buy the shares at a higher price and incur a loss. For example, if you want to buy 100 shares of Apple Inc (AAPL) in the stock market, you would need to invest $100,000 to buy 100 shares.
This initial outlay of funds is known as your margin, and it leaves you vulnerable to any fluctuations in price (the value of your trade will go up or down with the price movement). However, this does not happen on CFDs because you only need to invest a percentage of the total value. Let’s say that AAPL stock is trading at $160 per share, and you open a position worth $10,000 by putting down just 10% ($1,000) – if Apple’s shares increase by 5%, then your investment increases by 50%.
An Example of CFD Trading
Let’s say you think that the AUD/USD exchange rate will rise. You could go long on AUD/USD by buying one CFD contract, which will give you exposure to 100,000 units of currency. If the exchange rate does indeed rise, then you will make money on the trade. Conversely, if you think that the AUD/USD exchange rate will fall, you could go short on AUD/USD by selling one CFD contract, which will give you exposure to 100,000 units of currency. If the exchange rate does indeed fall, you will make money on the trade.
Trading CFDs is a popular way to speculate and gain exposure to various asset classes and currencies without actually purchasing them outright. The whole process is relatively straightforward – traders go long or short on an asset they believe has potential, wait for it to move as predicted and close out their position at a profit or loss. However, whilst trading CFDs can be profitable if done correctly, there are certain risks involved – we recommend that beginners read up further on CFD trading before attempting any form of investment themselves.
What Are the Risks of Long and Short Positions?
There are several risks involved with CFD trading, including the following:
You can lose more than you initially put in. For instance, if an investor goes long on one CFD contract and the underlying asset’s price moves against them by 20%, they will lose money (in this case, $2,000).
Investing in CFDs is highly leveraged – this means that you only need to put down a percentage of the overall value when opening a position. However, your losses will also be magnified by this amount. If you go short on one CFD contract and prices even rise slightly (by 0.5%), then your initial investment will completely wipe out your account balance.