What are CFDs? [video]

Foreign exchange or Forex for short - refers to the exchange of currencies on global markets. Watch this short video to learn more.

Investors can use CFDs to trade a wide range of markets including forex, indices, shares, commodities and more, from a single account.

How CFD trading works

When trading CFDs, a trader will open a position in a specific market. For example buying gold.

If the gold price rises, the trader can close the position to turn a profit. However if the gold price falls, when the trade is closed it will be for a loss.

One benefit of CFD trading is the ability to speculate on both rising and falling markets.

Example CFD trade

If for example, a trader thinks the price of the Swiss Market Index is expected to fall, they can sell or go short the SMI.

If the price falls, the trader stands to benefit, while if the price rises the trader will lose out.

CFDs are quoted in the same currency and typically have the same trading hours as the underlying market.For example, oil CFDs are traded in US dollars with 24-hour trading available - just like oil futures contracts.

Costs of CFD trading

There are two costs associated with CFD trading. The first is the spread, which is the difference between the price available to buy and sell.

The second is called the swap, or rollover, which is an adjustment to your P&L based on interest rates for holding the trade overnight.

The amount of these costs varies with each trade but is clearly displayed on the trading platform before placing the trade.

CFDs often receive preferable tax treatment such as no stamp duty, but remember taxes vary according to jurisdiction and individual circumstances. 

Leverage in CFDs

Using leverage to trade on margin, traders can open CFD positions with a smaller initial investment.

This makes CFDs one of the more cost-effective ways to trade because the spare capital can be deployed into other trades.

However, trading on margin also adds risk. It amplifies the effect of price changes on the trader’s account balance. For inexperienced traders this means an increased risk of losing the entire balance.

Traders should ensure they have a thorough understanding of the products, trading platform and the risks involved, before beginning to trade.

The most effective way to understand the way CFDs function is by spending time on a demo trading account in a risk-free environment before trading live.

If you haven’t already done so, make sure to register for a FlowBank trading account