With FOREX.com, it’s possible to trade an index using CFDs, or contracts for difference. CFD trading allows you to take a position on the price of an instrument without owning the underlying asset. One of the most unique aspects of CFDs is the ability to profit from falling markets as well as rising ones.
The three key features of CFDs are:
- CFDs are a derivative product
- They’re leveraged
- You can profit and incur losses from both rising and falling prices
CFDs are a derivative product
The term ‘derivatives product’ simply means that when trading CFDs, you don’t actually own the underlying asset. You’re simply speculating on whether the price will rise or fall. When you trade a CFD, you are agreeing to exchange the difference in the price of a market from the moment the contract is opened, to the moment it’s closed.
Let’s take stock investing as an example. Let’s say you want to purchase 10,000 shares of a FTSE-listed stock, like Tesco. Let’s say its share price is 280p, which means that the total investment would cost you £28,000, not including the commission or other fees your broker would charge for the transaction. In exchange for this, you receive a stock certificate, legal documentation that certifies ownership of shares. In other words, you have something physical to hold in your hands until you decide to sell them, preferably for a profit.
With CFDs, however, you don’t own those Tesco shares. You’re simply speculating, and potentially profiting, from the same movements in share price. And when you trade an index, you’re not purchasing the individual share – you’re speculating on the overall price of the index, which is influenced by companies within it.
What Is Leverage in CFD Trading?
Leverage means you gain a much larger market exposure for a relatively small initial deposit. In other words, your return on your investment is significantly larger than in other forms of trading.
Let’s say you want to invest directly in the DAX, which is priced at 14,000. To buy one contract, you’d need €14,000.
With CFD trading, however, you only need a small percentage of the total trade value to open the position and maintain the same level of exposure. With FOREX.com, leverage on indices are available at 5%. This means that you would only need to deposit an initial €700 to trade the same amount.
If the DAX rises 5%, the value of the position is now €14,700. So with your initial deposit of just €700, this CFD trade has made a profit of €700. That’s a 100% return on your investment, compared to just a 5% return if the index was invested in without leverage.
The important thing to remember about leverage, however, is that while it can magnify your profits, your losses are also magnified in the same way. If prices were to move against you, you may be closed out of your position by a margin call or have to top up your funds to keep it open. Therefore, it’s important to understand how to manage your risk.
If the Dax falls 5% to €13,300, your initial deposit of €700 incurs a loss of the same amount. That’s a -100% loss on your investment, compared to just a -5% loss if the shares were bought physically.
What Is ‘Trading on Margin’ with CFDs?
Trading on margin is simply another term to describe leveraged trading, because the amount of money required to open and maintain a leveraged position is called the ‘margin’.
How Do CFDs Work?
To understand how CFDs work, it’s important to have a good grasp of the following concepts, and how they apply to CFD trading:
- Spread and commission
- Deal size
Spread and Commission
CFDs are quoted in two prices: the buy price and the sell price.
If you believe the price of an asset is going to rise, you go long or ‘buy’ and you’ll profit from every increase in price.
If you believe the price of an asset is going to fall, you go short or ‘sell’ and you’ll profit from every fall in price.
The spread is the difference between the buy price and the sell price. When placing a trade on the market, the spread is also the main cost of the position. The tighter the spread, the lower the cost of trading. The wider the spread, the higher its costs. You can also view the spread as the minimum distance the market has to move in your favour before you could start earning a profit.
Trading CFDs is more similar to traditional trading than other derivatives, such as spread bets or options. This is largely due to the fact that CFDs are traded in standardised contracts, or lots. The size of an individual lot depends on the underlying asset being traded, often mimicking how that asset is traded on the market.
Duration of the Trade
More often than not, CFD trades have no fixed expiry. A position can be closed simply by placing a trade in the opposite direction to the one that opened it.
Placing your First Index Trade
Open your FOREX.com demo to follow these steps and open a practice trade.
You’ve heard news that two major companies are considering a merger. As a result, you think the Dow Jones (Wall Street on our platform) will rise, so you decide to take a long position on Wall Street.
Search for Wall Street in the platform and click the market to open a deal ticket.
You can choose to buy or sell Wall Street. Buying will give you a position that makes money if Wall Street rises, selling will earn you profit if Wall Street falls.
The number of CFDs you trade dictates how much profit or loss you make. Buying a single CFD will earn you $1 each time Wall Street moves one point.
Buy five Wall Street CFDs
If Wall Street gains 50 points and you close your position, then you will earn (50 x 5) $250. However, if it falls 50 points, then you would lose $250.
To close your position, you make a trade that is the opposite to when you opened. We bought five CFDs at the outset, so now we can sell five Wall Street CFDs to realise any profits or losses.
Sell five Wall Street CFDs