What is CFD?
CFD stands for Contract for Difference, which is a well known financial derivative that allows the investors or traders to speculate on the price movements of various financial instruments without owning the underlying asset. CFD includes stocks, indices, commodities, currencies, and cryptocurrencies and many more.
The key feature of a CFD is that it represents an agreement to exchange the difference between the opening and closing price of a trade, rather than the actual asset itself. In simple terms, CFD is not the value of the underlying asset, it refers to only the change of price in between the trade entry and exit.
How does CFD Work?
- Opening a Position: To initiate a CFD trade, a trader opens a position by entering into a contract with a broker. The contract stipulates the amount of the asset to be traded and the direction of the trade (buy or sell).
- Leverage: CFDs are typically traded on margin which means that traders can control a large position with a relatively small amount of capital. For example, a trader might put up 10% of the total trade value as margin.
- Settlement: When the position is closed, the difference between the opening and closing price of the asset determines the profit or loss. If the price of the asset rises, the buyer gains and vice versa.
Understanding CFD with an Example
Rahul buys 100 CFDs of ABC Ltd. at ₹500 per share, using 10:1 leverage, which requires a ₹5,000 margin to control a ₹50,000 position.
- Price Increase: If the price rises to ₹550, Ravi sells for ₹55,000. His profit is ₹5,000 (₹55,000 – ₹50,000).
- Price Decrease: If the price falls to ₹450, Ravi sells for ₹45,000. His loss is ₹5,000 (₹50,000 – ₹45,000).
This indicates how CFD impacts the profit and loss of the traders based on the price change and leverage.
Advantages of CFD
- Leverage: CFDs allow traders to use leverage which means that they can control a large position with a relatively small initial investment.
- Accessibility: CFDs provide access to a wide range of financial markets and instruments, which might otherwise be difficult to trade directly.
