In this article, I will explain what CFD stands for and what it is in trading, and will explain the different type of brokers that you can find in online trading, Market maker, ECN and STP.
CFD stands for “Contract For Difference”, and is considered as an advanced trading agreement that is used by retail traders, both beginners and experienced ones. As the name implies, in this type of trading you are having a financial contract with your broker where you agree to pay the difference in the settlement between the open and closing prices of an instrument that you trade.
When you trade CFDs, you don’t actually own the underlying asset, you’re investing only a small amount of your money into the position. This is called the “Margin”. There is no physical exchange of assets here, all you are doing is, you are buying a contract which says that you will pay the difference between an asset’s buy price and its sell price. When the price goes up the CFD broker will give you the profit and when the price goes down you agree to pay the loss to your broker.
CFDs are used by traders to place their trades (some traders love to call it price bets) on the price movement of an instrument. If you are expecting the price to go up then you need to buy the CFD, alternatively if you are expecting the price to go down then you need to sell an opening position.
My recommended CFD broker – ActivTrades
What Is ECN Broker?
ECN, stands for “Electronic Communication Network”. This type of brokers work based on an electronic communication network trading system in which many traders are buying and selling orders from different large liquidity providers who compete for the transaction. The main role of an ECN broker is to connect different market participants together at one place using the electronic communication network, so then they can trade with each other.
ECN trading platform is used to electronically match the participants in a trade for interested investors. This type of brokers comes under the category of non-dealing desk brokers as they are operating as a middleman between the trader and the market.
What Is STP Broker?
STP stands for “Straight Through Processing”. STP brokers offer straight through processing of trade orders from their clients directly to major banks for trade order execution. This type of brokers comes under the non-dealing desk category (similar to ECN) as they use a fully automated dealing system for their clients.
The smaller brokers use STP methodology to connect their clients to large broker firms. Then it is up to the larger brokers to decide whether to keep the trade internally or to connect the trader directly to the market. Also with this type of broker you can sometimes get better spreads due to the heavy competition between the market makers so the broker has ability to to offer their clients the best conditions for a trade.
How Do CFD Brokers Operate?
CFDs are not traded on major exchanges, it is traded through a network of brokers that organize the market demand and supply for CFDs and set the prices accordingly. There is a false common belief among traders that a broker makes money when a trader loses a trade, but this is not the case with true CFD brokers. The CFD brokers encourage their clients to win more and by doing so they will be able to generate more revenue over the longer term. In this case both the client and the broker get benefitted.
Generally, when you want to buy an asset, you need to invest a large sum of money, but this is not the case with CFD trading. While trading CFD instruments, a trader only invests a small amount of money, but he is not restricted to trade only the money he invested. He gets the privilege of trading a much larger amount using the leverage provided by the broker. This is possible with CFD trading because they act as a market maker and provide liquidity to their instruments. As the CFD is acting as your broker and also as a market maker you can get as much liquidity as you need to get within your capital limits.
While you trade in CFD the profit and the loss are calculated based on the price difference between when a contract is entered and when it is exited. The broker will pay you the difference between the price at the beginning of the contract and the price at the end. If a loss is made, then you need to pay the broker the difference.
If you would like to know about the calculation behind the profit or loss then you need to find the difference between the price at which you enter and the price when you exit, multiplied by the number of your CFD units.
Here is an example:
If you want to buy a CFD on the S&P500 shares, then the broker requires 5% down as the initial payment for the trade (it might vary from broker to broker).
If you buy 100 shares of S&P500 for $500 per share for a $50,000 position from which you need to pay 5% or $2,500 initially to the broker.
Let’s assume you opened the position with $500 per share and after a few months the S&P500 share price increases and is moved up to $1000 per share which would be $100,000 ($1000 * 100 shares), and you close the position with a profit of $500 per share or $50,000 in total.
The CFD is cash-settled; the initial position of $50,000 and the closing position of $100,000 are netted out, and the profit of $50,000 will be credited to your account.
Advantages Of Trading CFDs
The advantages of trading CFDs are as follows:
- Using the CFD system you can buy or sell an asset without owning it.
- CFD trading allows you to “trade on margin” which means you can “borrow” money from the broker to increase the leverage or size of the position.
- You get higher leverage with CFD while compared to other trading.
- Lower cash investments.
- CFD allows you to trade the price movement of assets including Forex,ETFs, stock indices, and commodity futures.
- CFD prices mirror directly what is happening in the underlying market.
- Low transaction costs.
- Transparency and ease of execution.
- Fast trade execution by the broker.
- No fixed contract size.
My recommended CFD broker – ActivTrades
Risk Warning: CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 85% of retail investor accounts lose money when trading CFDs with this provider. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.
Disclaimer: The information provided does not constitute investment research. The material has not been prepared in accordance with the legal requirements designed to promote the independence of investment research and as such is to be considered to be a marketing communication. All information has been prepared by ActivTrades (“AT”). The information does not contain a record of AT’s prices, or an offer of or solicitation for a transaction in any financial instrument. No representation or warranty is given as to the accuracy or completeness of this information. Any material provided does not have regard to the specific investment objective and financial situation of any person who may receive it. Past performance is not a reliable indicator of future performance. AT provides an execution-only service. Consequently, any person acting on the information provided does so at their own risk.
Yours to your success,
Certified Financial Technician