A CFD Trade in Action

Contract for Difference (CFD) trading allows an investor to bet on the movement of a security without actually owning the security itself. A CFD trader sells these contracts and the trader will charge a lower percentage than a traditional stock broker. The lower commission and traditionally high leverage amount is what attracts many investors to CFD trading. To understand how a CFD trade actually works, it is valuable to consider an example.

Step One: Locate a Trade

The first step in trading CFDs is actually establishing a contract. You must pick a security you wish to bet on. To do so, you may want to ask an analyst to prepare a synopsis of several securities. You can also watch a security's movement over time. On the other hand, you may simply ask a CFD trader which contracts they would recommend. You stand to profit the most from a CFD if the security's price varies greatly. Pick a security you believe will be highly volatile in the future.

Step Two: Consider Financials

Next, decide how much you would like to spend on the CFD. The more you spend, the greater your chance for profit. With a CFD, the leverage ability may be very high. This means your trader will be willing to extend you a fair sized loan to make your bet. For example, if the leverage is 20 percent, you can use just $5,000 to purchase a $25,000 CFD. If the leverage is only 10 percent, which is not uncommon, you could purchase a $50,000 CFD with just $5,000.

Step Three: Establish a Contract

Notify your trader to set up a contract. If you have decided to purchase $25,000 at 20 percent leverage, you will have to pay $5,000 up front. You will not actually be purchasing shares, but the current price of the shares of the security of your choice will be what determines the ultimate contract. For example, if Security Alpha is currently trading at $5 per share, you will be tracking 5,000 shares with your CFD. When Alpha's price moves $1 per share, you will earn $5,000. Your CFD will have an expiration date. You can choose to sell and settle the CFD prior to that expiration date, or you can hold the CFD until expiration. The ideal goal is to sell when you can profit the most.

Step Four: Monitor Movement and Settle Contract

You should monitor the movement of your contract. For example, let's assume your 5,000 CFDs of Alpha go up to $1.75 per share, and you anticipate the price will fall prior to the expiration of your contract. You can sell your contract to another investor. In this case, your only profit will be the difference in this sales price and your original cost. You can also decide not to sell, and instead hold on to the CFDs until expiration. Let's say Alpha's price has dropped back to $1.60 per share, you will make a profit on the difference. Your earnings will be $.60 per share for the 5,000 shares, resulting in a $3,000 profit.