CFD trading in its most basic form is no different from any other market transaction in that it involves an agreement between two parties (a buyer and a seller) to transfer a contract at a specific price and time. One common misconception about CFD trading is that money can only be made when markets are in an uptrend, but nothing could be further from the truth. Here we will outline some of the basic elements that allow CFD investors to achieve gains in both rising and falling markets.
In trading jargon, the purchase of a CFD is typically referred to as a ‘long position’ and this generally requires an expectation that the value of an asset will increase over the life of the investment contract (the CFD). In order for this purchase to be made, however, there must be a party willing to take the opposing view and sell that asset to the buyer. The selling of an asset is often referred to as a ‘short position’. One essential concept that new traders must understand is that CFD trading is flexible enough to allow for a wide variety of strategies and that traders are able to establish either long or short positions at any time, based on their individual market expectations.
First, we will look at an example of a long position. Let’s assume that we have a favourable forecast (scenario A) for the economic prospects of Google. Say the current market value of Google stock is $890, and we buy 100 shares, for a total price of $89,000. The following week, prices have appreciated to $895 per share, creating a total gain of $500 ($89,500 in current value minus the purchase price of $89,000). From this gain, we must deduct trading costs (which will vary depending on your broker agreement). Another factor to consider is the use of leverage, by which you can commit your margin capital to control proportionately larger trade sizes, as this is another key feature of CFD trading.
In scenario A, we have assumed the initial forecast was accurate and that Google stock has risen in value. You should remember, however, that if prices had moved in the other direction (showing a decrease in stock value) our losses would match the change in price seen during the life of the CFD (plus trading costs). Hence it is always prudent to use protective stop orders so that erroneous market forecasts do not result in significant trading losses (especially when using leverage).
In our next example (scenario B), we will take the opposite viewpoint, a negative price forecast for Google stock, and identify ways to make gains from downward price movements. Let’s again assume that Google stock is valued at $890, but in this case (since we have a negative outlook on Google) we will open a CFD to sell, or ‘short’, 100 shares of Google. The total value of the position is the same ($89,000) and again this can be controlled with a margin deposit rather than the full cost of the shares, but in this case if prices move in an upward direction we will actually start to lose money.
For the sake of explanation we will assume that shares prices fall, in this case to $885 per share. We see that our initial forecast was correct and we choose to close the position at a gain. The difference between the opening and closing prices is $5, making our total gain equal to $500 ($5 x 100 shares). From this we deduct our CFD provider’s trading fees to calculate the total gains. The same rules apply to both long and short positions, the only difference is that ‘longs’ are successful in bullish market environments while ‘shorts’ are only successful when prices decline.
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