What is CFD trading?

CFD stands for Contract for Difference. It was initially designed in the 1980s to help businesses manage their risk. If a business is involved in importing and exporting goods, it could find that its profit/loss margins are extremely volatile thanks to currency fluctuations.

In other words, when you buy something from abroad using a different currency than your own, the value of that foreign currency can change after you have made your purchase – resulting in either a healthy profit or a crushing loss. The CFD allows both buyers and sellers to avoid this asymmetric risk.

In essence, what happens when you open a CFD position is that one side agrees today with another party that they will take on an obligation to pay or receive money based on certain conditions. The conditions relate to changes in the value of an underlying asset (stock index, commodity or currency pair).

CFD trading is not the same as owning an actual share in a company. Although CFDs are traded on margin, you aren’t buying ownership in anything – instead, you’re simply speculating on whether the price of that asset will increase or decrease over time.

That means that when your profit comes at expiration, it doesn’t come in the form of dividends – instead, it comes through adjustments made to your initial position. If the closing position is at a loss, then some money may also be taken from your deposit to cover this loss.

How does it work?

Essentially what happens when you open a CFD position is that one side agrees today with another party that they will take on an obligation to pay or receive money based on certain conditions. The conditions relate to changes in the value of an underlying asset (stock index, commodity or currency pair).

Opening a long position

When you open a long position, it means that the rate of return is calculated as if you were borrowing funds from your broker and purchasing shares with those borrowed funds. Therefore there is no need for further approval from the bank as your broker has already provided collateral.

However, CFDs may come with different terms, requiring traders’ approval for opening positions beyond a prespecified rate. If you close your position at a loss, then some money may also be taken from your deposit to cover this loss.

When you open a short position, this means that the rate of return is calculated as if you were selling shares and then purchasing those very same shares back to repay your broker. Therefore there is also no need for further approval from the bank as your broker has already provided collateral. However, CFDs may come with different terms, requiring traders’ approval for opening positions beyond a prespecified rate.

Long and short

Long and short positions can be entered to profit when an asset’s price moves up (long) or down (short). The profit/loss will depend on the change in the underlying asset price over time.

Open Position

A long position occurs when a client buys a currency pair at today’s rate. A short position occurs when the client sells a currency pair at today’s rate.

Close Position

When you close your position, this means that you are either buying back the assets you initially sold to take a short position or getting rid of assets bought with a long position. The difference between the initial and closing prices is your profit or loss.

Margin

Margin trading allows traders to borrow funds from brokers to make trades on their behalf using leverage. The size of the margin requirement depends on whether it is for a long or short trade and what instrument you’re trading (stock market, forex). The riskier the asset traded, the higher the amount that traders must deposit as collateral.

In conclusion

In essence, what happens when you open a CFD position is that one side agrees today with another party that they will take on an obligation to pay or receive money based on certain conditions. The conditions relate to changes in the value of an underlying asset (stock index, commodity or currency pair).

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