What is CFD and how does it work?
CFD is an instrument that allows traders to trade in price movements of an asset without actually owning that asset. It differs from spot trading, where you need to buy or sell an asset and wait for its price to change.
There is no delivery of the asset when you open or close your CFD positions. Opening a position, you become exposed to the price fluctuations of an underlying asset. Closing a position, you fix a profit or a loss generated as a result of those price movements.
CFD in general:
- The agreement related to the asset price difference between the time the position is opened and closed;
- Trading without buying or selling the asset: instead, positions are opened according to the expected price movements;
- Speculation on the price changes: profit or loss depends on whether the price behavior was predicted correctly or not.
CFDs are traded on margin, meaning a trader borrows funds from the broker and uses this leverage to multiply potential gains. Leverage also works in the opposite direction, multiplying losses.
Let’s look at a specific example:
Suppose you anticipate that the BTC price will go up. You open a Long Position with BTC price on the € 8,000 mark.
Because CFDs are traded with leverage, the amount of capital required to open a position of a certain size is smaller than the actual position size. For example, you use 10x leverage. That means, to open a Long Position for 1 BTC, you only need 0.1 BTC. This amount will be held in a “collateral” while your position is open and will be called “Used Margin”. With that, you will incur gains and losses from the price movements of the entire 1 BTC (with 10x leverage, it is 10 times larger than your own capital that you used!).
When you open the position, you will not actually own 1 BTC. You are just speculating on the future price movements. If your bet plays out, you will win. If not - you will incur a loss.
Suppose the BTC price increases to € 9,000. That means, with your leverage, you are in for € 1,000 gains (Close Price - Open Price). Your net profit is that minus the fees (as there could be fees for the opening position, closing it, and for keeping it open for a number of trading periods).
If, on the other hand, the price drops to € 7,000, your loss is € 1,000 plus the fees (Close Price - Open Price).
It is important that leverage both multiplies potential gains and losses. Hence, CFD trading is considered an advanced trading strategy connected to higher risks.