An Overview of CFDs
A CFD (contract for difference) is a contract that enables you to trade on the changing prices of financial instruments, like shares, forex, stock indices and commodities.
Essentially, if you buy a CFD and its value goes up you make a profit.
If its value falls, you make a loss.
Unlike conventional investing, if you buy a CFD you have no claim to the underlying asset, you just have the right to trade on it.
One of the advantages of this style of trading is that you can open a position with a relatively small deposit, and the potential return on this investment can be much larger than in conventional investing.
For example, let's say the AUD/USD is priced at 1.
0673/1.
0676 in the market and you think it will go up.
One CFD contract on the currency paid is worth AUD100,000, which will buy you USD106,760.
Before margined forex and CFDs became available to the general public, the only way you could have traded the Australian dollar against the US dollar would have been to exchange the physical currency.
However, with CFDs you can access an AUD100,000 contract with a deposit of just 0.
5% of the position.
So if your position is worth USD106,760 (AUD100,000 x 1.
0676), your deposit would be USD533.
80.
The next day the AUD/USD rises to 1.
0701/1.
0704 and you decide to sell your contract and take your profit.
Your gross profit (excluding commissions, overnight financing and any other charges) is calculated as the value of your closing position minus your opening position.
Closing position = AUD100,000 x 1.
0701 = USD107,010 Opening position = AUD100,000 x 1.
0676 = USD106,760 Gross profit = USD107,010 - USD106,760 = USD250 A worked example is one of the best ways to see how to trade CFDs.
In the previous example, you can see that USD250 is a 47% return on your initial investment of USD533.
80.
By contrast, if you had been trading physical currency your return would have been a much smaller fraction of your investment.
This leverage (the ability to access a large position with a relatively small deposit) is one of the great advantages of trading forex as a CFD.
However, it is important to note that your losses are magnified to the same degree as your profits, which can result in your losing more than your initial investment.
This is why it's essential for traders to manage their risk, by trading mini-contracts rather than standard contracts, by limiting the amount they risk per trade, and by using risk management tools like stop losses and limit orders.
Essentially, if you buy a CFD and its value goes up you make a profit.
If its value falls, you make a loss.
Unlike conventional investing, if you buy a CFD you have no claim to the underlying asset, you just have the right to trade on it.
One of the advantages of this style of trading is that you can open a position with a relatively small deposit, and the potential return on this investment can be much larger than in conventional investing.
For example, let's say the AUD/USD is priced at 1.
0673/1.
0676 in the market and you think it will go up.
One CFD contract on the currency paid is worth AUD100,000, which will buy you USD106,760.
Before margined forex and CFDs became available to the general public, the only way you could have traded the Australian dollar against the US dollar would have been to exchange the physical currency.
However, with CFDs you can access an AUD100,000 contract with a deposit of just 0.
5% of the position.
So if your position is worth USD106,760 (AUD100,000 x 1.
0676), your deposit would be USD533.
80.
The next day the AUD/USD rises to 1.
0701/1.
0704 and you decide to sell your contract and take your profit.
Your gross profit (excluding commissions, overnight financing and any other charges) is calculated as the value of your closing position minus your opening position.
Closing position = AUD100,000 x 1.
0701 = USD107,010 Opening position = AUD100,000 x 1.
0676 = USD106,760 Gross profit = USD107,010 - USD106,760 = USD250 A worked example is one of the best ways to see how to trade CFDs.
In the previous example, you can see that USD250 is a 47% return on your initial investment of USD533.
80.
By contrast, if you had been trading physical currency your return would have been a much smaller fraction of your investment.
This leverage (the ability to access a large position with a relatively small deposit) is one of the great advantages of trading forex as a CFD.
However, it is important to note that your losses are magnified to the same degree as your profits, which can result in your losing more than your initial investment.
This is why it's essential for traders to manage their risk, by trading mini-contracts rather than standard contracts, by limiting the amount they risk per trade, and by using risk management tools like stop losses and limit orders.
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