Module 7: Basic of CFD Trading 

Diving into the complexities of the financial market opens up new avenues for traders. The financial market offers a spectrum of opportunities for engaging with various financial instruments. Prominent among these is Contracts for Difference (CFD) trading. 

This part of the course is crafted to break down forex CFD trading by explaining its fundamental aspects, potential upsides, and downsides, and distinguishing it from conventional trading practices. 

7.1 What is a Contract for Difference (CFD)? 

A CFD is a financial derivative that allows traders to speculate on the price movement of assets, including stocks, without owning the underlying asset. The contract is a binding agreement between a trader and a broker to exchange the difference in the price of an asset from when the contract is opened to when it is closed. 

Here are some unique characteristics when it comes to trading CFDs: 

• Leverage: CFD trading is known for offering high leverage, meaning traders can control a large position with a relatively small amount of capital. However, while leverage can amplify profits, it can also magnify losses. 

• Going Long or Short: CFDs provide the flexibility to make returns from both rising and falling markets by going long (buying) if you anticipate the asset’s price will rise or going short (selling) if you expect it to fall. 

• No Ownership: Since CFDs do not involve owning the actual assets, traders can bypass certain restrictions and costs associated with physical ownership, such as stamp duty. 

7.2 How Do CFDs Work? 

CFDs operate on a principle that might seem complex at first, but it’s actually quite straightforward once broken down. Essentially, when you trade a CFD, you’re engaging in a contract based on the price movement of an asset, without actually owning the underlying asset. The core of a CFD trade is the speculation on whether the value of the asset will rise or fall. 

At the core of CFD trading is the concept of leverage, which allows traders to open positions much larger than their actual investment capital would permit. This means that even small fluctuations in prices can lead to significant profits or losses, making it a double-edged sword. It’s crucial for traders to understand leverage’s implications fully and to use risk management strategies to mitigate potential downsides. 

Another key aspect of trading CFDs is the ability to go long or short. This flexibility means traders can profit from both rising and falling values, offering opportunities in diverse market conditions. Whether you’re optimistic about an asset’s future and choose to go long, or you predict a decline and decide to go short, CFDs provide a versatile platform for engaging with the financial markets. 

7.3 What Are the Costs Associated with Trading CFDs? 

Trading CFDs can open up a world of opportunities. However, like any trade, it comes with its own set of costs. This section breaks down these costs to help beginners understand what to expect when they start trading CFDs. Knowing these fees can help you plan your trading strategy more effectively. 

1. Account Charges 

When you sign up with a broker to start trading, you might encounter some fees related to your account. These could include: 

Activation Fee: A one-time charge for setting up your new trading account. 

Inactivity Fee: A fee charged if you do not make any trades over a certain period. 

2. Holding Fees (Overnight Fees) 

If you decide to keep a CFD position open for more than a day, expecting a mid-term trend to favour your trade, be prepared for holding fees (also known as swaps or overnight fees). These are charged daily and can either add a small cost to or slightly reduce the value of your position, depending on the direction of your trade and the broker’s policy. 

3. Transaction Costs 

Some brokers might take a cut when you move money in or out of your trading account, charging a percentage of the deposit or withdrawal amount. 

4. Margin Rates 

Trading with leverage allows you to open larger positions than your current account balance would otherwise permit. The catch? You’ll need to ensure that you have a percentage of the total value of your position available in your trading account. This margin rate can range from 1% to 50%, depending on the asset and the broker. 

5. Spreads 

The spread is a fundamental cost in CFD trading, representing the difference between the buy (offer) and sell (bid) prices of a CFD. This cost is realised the moment you open a position, as you’ll need the asset price to move beyond the spread to start making a return. 

6. Commissions 

Especially relevant in CFDs, commissions are fees that brokers charge on each trade you make. The amount can vary based on the broker’s policy and the size of your stake in the trade. 

A Note on Taxes 

Depending on your country of residence, you might also be liable for taxes on profits made through CFD trading. It’s important to be aware of these potential tax implications to manage your investments wisely. 

7.4 Understanding Margin and Leverage in CFD Trading 

Margin trading involves the use of leverage, which allows traders to borrow funds to control a larger position size. This means that both potential gains and potential losses are amplified. 

CFD trading is typically conducted Over the Counter (OTC) or off-exchange, with the broker acting as the intermediary for the client. 

Unlike traditional stock exchanges where the exchange itself stands in the middle of trades, margin trading through CFDs allows clients to access some of the largest markets in the world, including commodities, indices, and cryptocurrencies. 

What is leverage? 

Leverage in CFD trading is a powerful tool, essentially acting as a multiplier of both potential returns and potential risks. It allows traders to make larger trade sizes, with a small amount of capital. In Australia, the Australian Securities and Investments Commission (ASIC) closely regulates leverage limits for CFD trading to protect both retail and wholesale traders. 

At the moment, ASIC defined leverage limits stand at: 

Product	Leverage
Forex major pairs	30:1
Forex minor pairs	20:1
Gold	20:1
Oil	10:1
Other commodities	10:1
Indices	20:1
Share CFDs	5:1
Cryptocurrencies	2:1
ETFs	5:1

Leverage is required as most of the CFD products offered are OTC professional markets, which generally trade with a large size.  The leverage allows the broker to enter the client’s order within the professional market to be executed.  

7.5 Choosing the Right Platform for CFD Trading: Features, Popular Options, and Order Types 

In order to access these markets, a trader will need to utilise a platform provided by the broker. The platform automatically calculates the leverage allowed on the client’s account and will let the trader place orders to execute in the market. 

The most popular platform offered by CFD brokers is issued by MetaQuotes. This can be either MetaTrader 4 (MT4) or MetaTrader 5 (MT5). This platform has the largest market share and is the most popular for trading CFDs. 

There are other platforms available as well, including TradingView and CTrader, which are less popular with traders, but also give traders access to the global markets. 

Orders 

Orders can be either at the market or pending. 

At the market means that the client will enter their order at the current market price. 

There are four major types of pending orders a trader can place for their trading: 

• Buy long: A buy long order is placed when a client believes the traded asset will rise in price. 

• Sell Short: A sell short order is placed when a client believes the traded asset will fall in price. It allows the trader to sell the asset (without owning it) first, to then buy it back to close the position. 

• Stop Loss: A stop loss order is placed below a long trade or above a short trade. The Stop loss will automatically trigger if the position goes against the trader by a predetermined amount and limit the potential loss on a trade. 

• Take Profit: A take profit order is placed higher for a long trade and lower for a short trade and allows the trade to be closed at a profit for a client, once a predetermined movement has occurred.  

7.6  Differences Between CFD Trading and Normal Trading 

Diving deeper into the distinctions between traditional trading and forex CFD trading reveals nuances that are crucial for traders to understand. These differences not only affect the mechanics of trading but also influence strategy, risk exposure, and potential outcomes. 

	Traditional Trading	Forex CFD Trading
Nature of Trading	Direct buying and selling of the products.	Speculation on currency pair price movements without owning the currencies.
Market Access	Access through forex brokers to global markets.	Broader access including currencies, indices, commodities, and shares from a single platform.
Ownership	Involves actual ownership of currencies.	No ownership of the underlying asset.
Leverage	Limited leverage, focusing more on direct exchange rates.	High leverage available, magnifying both potential returns and losses.
Risk Management	Managed through traditional methods like stop-loss orders; lower risk and reward due to limited leverage.	Requires careful risk management due to higher leverage; potential for higher rewards but also higher risks.

Understanding the key differences between traditional trading and CFD trading is essential for traders choosing the path that best suits their investment goals, trading style, and risk tolerance.  

While traditional trading offers a more straightforward approach to the financial markets CFD trading provides flexibility, enhanced market access, and the potential for significant returns through leverage. However, this comes with increased risk, underscoring the importance of informed decision-making and effective risk management in the dynamic world of forex trading. 

Quiz

Module Recap 

• A CFD is a financial derivative that allows traders to speculate on the price movement of assets, including stocks, without owning the underlying asset. 

• There are some unique characteristics of CFD such as leverage, ability to go long or short and no underlying asset ownership. 

• CFD trading allows for speculation on the underlying asset price movements with leverage, offering the ability to make potential returns from both rising and falling values without owning the actual currencies, thus requiring careful risk management. 

• Trading CFDs involve various costs including account charges, holding fees, transaction costs, margin rates, spreads, and commissions, all of which are essential for traders to understand and consider when developing their trading strategy. 

• Margin trading facilitates access to global markets through brokers, requiring traders to pay a portion of the position’s value upfront, which amplifies the potential outcomes of trades. 

• Leverage in CFD trading magnifies both potential returns and risks by allowing traders to control large positions with a relatively small capital investment, subject to regulatory limits to protect traders. 

• Traditional trading involves the direct exchange of currencies and offers lower risk with limited leverage, whereas forex CFD trading allows for speculation on currency prices without ownership, providing broader market access and the potential for higher returns at an increased risk level due to higher leverage.