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CFD: what it is and how it works

When trading on the financial markets, traders can often come across the term CFD. So what are CFDs? Should traders trade CFDs? How risky is CFD trading? The following article will help traders learn more about this term.

What are CFDs?

CFD is an English acronym for the phrase contract for difference. The contract for difference (CFD) is a derivative product that allows you to speculate on financial markets such as stocks, indices, commodities, forex…

but without owning the underlying asset. When traders trade CFDs, they bet on the price movement of the support and expect to make a profit between the difference between the opening and closing prices.

The trader places a buy order. When the price rises, the trader closes the order and takes a profit. Instead, the trader places a sell order. If the price drops, the trader closes the order and takes a profit.

What is the cost of trading CFDs?

When trading CFDs, there are some fees as follows:

Spread: The first commission of any CFD transaction is the spread. The spread is the difference between bid and ask prices. The trader enters a buy position at the bid price and closes the position at the ask price. Each broker will offer a spread for each different asset class. In addition, the spread also changes depending on the weather. For example, at the time of the release of the news, the spread is usually higher than normal times. The liquidity of each asset class also affects the spread. Highly liquid and heavily traded assets have smaller spreads.

In addition to the spread, CFD trading also has a commission to hold an overnight buy position. Traders typically pay an interest fee if they hold positions overnight for leveraged trades. This fee depends on the leverage ratio used by traders. The trader has to pay an overnight commission for a leveraged buy order because the broker then lends money to the trader to open the position. However, if a trader holds a leveraged selling position overnight, the trader will receive this commission on the account.

In addition to the above fees, if you trade stocks, some brokers also charge a fee for CFD transactions on shares. However, many brokers now allow stock trading with 0% commissions with leverageless trades such as eToro and Capital.com.

What are the benefits of trading CFDs?

CFDs allows buy and sell orders

The most significant difference and advantage of CFD trading is that traders can trade CFD products in both buying and selling directions. If the trader sees the price rise, he enters a buy order. Conversely, if the trader believes that the price will fall, the trader places a sell order. If the price goes in the right direction, the trade is profitable and vice versa.

The disadvantage of trading the underlying asset is that traders can only enter the market when the market is rising. However, with CFDs, whether the market has an upward or downward trend, traders have the opportunity to trade profitably.

CFDs allow the use of high leverage.

In addition, when trading CFDs, traders are also allowed to use high leverage to increase trading volume with only a much smaller margin. Each broker will offer different levels of leverage. However, the lowest leverage is 2:1 and the high leverage can go up to 500:1 (with Capital.com broker).

The higher the leverage, the less capital a trader uses per trade and the higher the profit potential. However, leverage is always a double-edged sword, and higher profits mean that the trader faces the same risk of loss if the trade goes in the opposite direction.

Opportunity to trade a variety of assets, different regions on one platform

Usually, CFD brokers offer a wide range of different asset classes globally. Traders can trade stocks, indices, cryptocurrencies, commodities, forex and more on one platform. In addition, brokers also provide assets in many different countries and regions. This makes it convenient for traders to handle all transactions.

What are some disadvantages of CFDs?

Big risk.

When it comes to CFD trading, traders often appreciate the flexibility of this product. However, traders cannot deny the risk when trading CFDs. CFD trading is always risky in terms of liquidity and profit margins. If the trader predicts the wrong direction of the price, the trade loses too much due to leverage and the broker is forced to close the position. This usually does not happen with investors of underlying assets.

Another risk when trading CFDs is that the market has too much volatility, or slippage occurs at times of great news. At that time, the stop-loss order does not close the order in the original position. This caused the loss of trade more than initially expected.

High transaction costs.

CFD traders usually trade for short periods. Continuous trading causes traders to pay the spread costs for each trade many times. These spreads can significantly affect profits.

In addition, if a CFD trader holds an overnight position with leverage, an additional swap fee may be charged to the broker.

The CFD market is not strictly regulated.

Agencies or governments do not heavily regulate the CFD market. CFD traders often trade on the platforms of reliable brokers so as not to encounter scam situations, not withdraw money when profitable, cheat in spreads… However, choosing brokers Getting among thousands of brokers on the market with new traders is challenging and takes time to learn.

Conclusion: What is a CFD?

Above is some basic information about CFDs. CFD trading has many advantages. It requires little capital, the opportunity to trade a variety of different assets on one platform. Traders can trade in any rising or falling market. However, traders need to choose reliable brokers and use leverage, stop loss… appropriately to control risks.

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