I would like to note that CFD’s are not permitted in certain countries.
Trading CFD’s can be a complicated process, but nothing is simple when it comes to the stock market. Hopefully this will bring you some clarity on how and why people trade CFD’s and how they do it on currency.
What is a CFD?
Contract for Difference (CDF), meaning you do not actually buying the asset itself; you are opening a contract with a CDF provider. This contract is simply a mirror of the actual asset. Instead of buying an asset and giving the traditional broker a 50% margin, you are only required 5% cash outlay to open the trade.
What is trading currency?
Since we want to buy some CFD’s on currency it is important to know how currency trading works. When you trade currency you do it at the rate (price) one currency can be traded for a different currency. Because of this they are always quoted in pairs such as EUR/USD, which stands for the Euro and the US Dollar.
Now, the rate is determined by how many US Dollars one Euro can purchase. So, if you think the Euro increase in value you would buy Euros with the US Dollars. When the Euros go up you sell them back for a profit.
Explanation/example of trading CFD on currency
Let’s say we are ready to buy some Euros, they are quoting us $25.26. We decide to buy 100 shares. A 5% margin is required so we give our CFD broker $126.30, if we were doing it traditionally from the trader on a 50% margin we would have to pay $1,263.
If the Euro were to appreciate and reached a price of $25.76, since we are not trading actual stock it is possible that our CFD price would be $25.74. If we were to sell our Euros at this price we would only gain about $46 to $48. In other words, we gave someone $126.30 to cover the margin and made a profit of $46. Had the Euro decreased we would had a loss.
Some say CFD’s give you much higher leverage than traditional trading. CFD margins can start as low as 2% and go up to 20%. Lower margins means less capital outlay for you the investor, and has the potential for great returns. However, this also means there is great potential for significant loss.
There are no shorting rules or borrowing of any kind. Sometimes you come across certain markets that have rules prohibiting shorting at certain times. Since there is no ownership of the asset there is no borrowing or shorting cost. Actually, there are very few charges for trading CFD; most brokers don’t even charge commission fees and no day trading requirements.
Since you initially have to pay the spread on exit and entry it pretty much eliminates profit on small moves. It can also become very costly if a large price movement does not occur. The spread also increases the losses by a small amount and decreases profits by a small amount.
You should always keep in mind that the CFD industry is not highly regulated. The credibility of a broker is based almost solely on his reputation and financial position. There are many good ones out there but be sure to do your own research and know who is handling your money.