What Are CFDs?
CFD’s or Contact of Difference is a contract in between a trader and a CFD provider. When a trader buys a CFD, he invests only a fraction of the money, called the Margin. This contract bonds both the sides to cash settlements. The amount of settlement between an investor and a CFD provider is the difference between the opening and the closing prices of the trades in the market.
When a trader buys a CFD for an asset that is trending upwards in the market, the trader is said to be going long. The reverse of this is when a trader buys a CFD where he speculates the price to fall. This is termed going short.
How do CFDs work?
A trader invests in a CFD provided by a CFD provider for the diverse portfolio of trades he might be interested in, like currencies, stocks, indices etc. Buying assets, in any market needs money. However, when a trader invests into a CFD, he invests only a fraction by paying for the margin. In CFD trading terms this is called “trading on the margin”. This minimal amount or the margin is defined by the CFD broker. However, this does not mean that the trader will have to trade for that minimal amount only. For the margin invested, the trader can trade for a much larger amount, which is defined as the effects of leverage. Moreover, unlike in other markets, a trader here does not have to actually buy the asset to trade in it. He invests in the CFD, takes up a position and starts trading the asset without actually buying and owning the asset.
From this point on, however, the CFD provider will also track the movement of the asset. Here is the most interesting feature of CFD. Recall the fact that a trader at this point in time does not own the asset and is trading the same via the CFD provider. When the asset makes an upward movement, as a trader he can put up more money by taking on the leverage facility provided by the CFD provider.
However, what happens when the market starts down trending? At this point in time, had the trader owned an asset, he would have sold the same to save himself from losing money beyond his investment. With CFDs, a trader can do the same even though he does not own the asset. As the market starts down trending, a trader can sell the CFD and take away some profits.
Read here: How to Trade Cryptocurrency Via CFDs
How do CFDs or CFD provider’s make money
Until now, we have seen how traders’ profit from CFDs. However, how do CFD providers make their living? The way CFD providers make money is through :
• Financing; and
This is a direct fee charged by the CFD providers from the traders. The catch here is, however, about the trader winning or losing a trade. For every profit that the trader makes, the CFD broker earns his commission. The commission fee goes down with a bad day in the market
In the trading domain, the transactions occur via buying and selling of assets. The buyer will buy at a low price and sell at a higher price. This price fluctuation occurs on the basis of demand and supply. The difference between the selling price and the buying price is referred to as the “spread”.
One of the ways that CFD’s make money is from spreads. Spreads are always inclusive of a CFD provider’s fee. While giving the trader the final price to buy in, the included fee is what makes the price a little costlier. Hence, with every buy that a trader makes, CFD providers take their profits.
CFD brokers allow traders to trade on margins. This allows traders to trade for more than what they can invest and this is known as the leverage. The margin requirements are strictly regulated by the CFD brokers. Hence the CFD providers already have a marked percentage to take away from a profitable trade. The margin, which is the minimum percentage that needs to be invested in by the trader, also has the broker’s portion marked off. Hence the leverage that a trader enjoys is inclusive of the broker’s portion.
Netting clients, one against the other:
Traders opting for CFD trading go either long or short. The longer a trader trades, the more interest he pays. However, when ‘a trader goes short, the “interest” bit is taken off the chart. Moreover, when a trader trades long, it can at times compensate for the short trades, which leaves the CFD broker with nothing. At this point in time, a CFD broker will make his profits from the difference of interest rates as it arises out of the positions held by the broker.
CFDs are flexible and hence can be used for trading in any market. Here is the advantage that this flexibility lends a CFD broker, via hedging. The CFD brokers play out the market by pairing liabilities to various contrasting positions in the markets. In the process, when a trader makes a profit, he can counterbalance his loses. Here the difference in prices of a win and loss will profit the broker.
CFDs are interesting and are increasingly becoming popular amongst the trading community. For all the convenience that a CFD provides a trader with, CFD providers or brokers also make their money from the trading that the traders carry out with CFDs. Yet the CFD brokers are always looking for innovative ways to make money.