How Does CFD Trading Work? Explanation With Examples
How Does CFD Trading Work? This has been the question of almost every trader newly venturing into CFD trading.
CFDs are one of the most popular trading instruments and there have been doubts on how CFDs work due to its unique nature.
Without owning any of the CFD assets, you can profit from both rising and falling markets.
Does that get you interested in CFD trading? Do you want to give CFD trading a try? You need to learn how it works first.
Hence we are writing this article to inform you about CFDs. We will take a look at its definition, how it works, where and how to trade it.
After reading our guide, you should feel confident to venture into the world of CFD trading. Let’s begin.
What Are CFDs?
To understand how CFDs work, we have to know what CFDs are first.
They are financial derivative products that are traded Over the Counter (OTC).
Here, a contract is formed between the buyer and the seller where they exchange the difference in the opening and closing price of the underlying asset.
The traders don’t own CFD assets. They rather speculate or bet on its market price movements.
The range of assets in CFD trading is diverse. You can trade anything from stocks, shares, indices, cryptos, commodities, and ETFs.
Usually, trading CFDs takes place through a decentralized platform such as a trading platform offered by a CFD broker.
CFDs don’t have any expiry on them and you can keep your position for as long as you wish.
However, there is an overnight fee that is incurred if you don’t close your position within the same day.
So trading CFDs on a long term basis can get expensive quickly.
With CFDs, you have the freedom of placing trading in both directions as all you have to do is predict the market accurately, be it a gaining or declining market.
We will discuss about CFD trading platforms and the features required in a CFD trading platform later in the article.
Features Of CFD Trading
CFDs have certain interesting features and characteristics. To trade CFDs with confidence, you need to understand its features.
We listed the salient features of CFD here:
No ownership
Unlike shares, where you own the assets you trade, CFDs don’t have any ownership properties.
You only bet on its price movements. The CFD contract is derived from the price of the asset.
When you own CFDs of a company, you don’t own any portion of the company. Nor can you participate in the company decisions.
Go short or long
With CFDs, you have the ability to trade both long and short. That means you can buy when you anticipate an increase in the price of the asset or sell when you think the price will drop.
This way, you can make money even from falling markets.
As a CFD trader, your goal is to predict the price movement irrespective of the direction the price moves.
Margin and Leverage
CFDs are leveraged products. You need to pay a small deposit to open a position.
This deposit is known as margin. This makes CFDs very attractive to trade.
You can bet on large positions using small deposits.and thus, you can gain profits quickly. The opposite is true as well.
If your position goes against the market, you lose more than you invest.
Margin and leverage make CFDs both attractive and risky. So keep in mind of the leverage ratio of your trade.
No expiry date
CFDs don’t expire. Basically, they don’t have any fixed expiry dates on them. CFD positions last as long as you keep them open.
At the end of the trading day, you have the option to continue or close your position.
However, there is a fee charged when you keep your position overnight.
This fee is known as rollover fee or swap fee. If are holding a short position, you are eligible for the fee and if you hold a long position, that fee will be deducted from you.
The range of trading instruments
CFDs aren’t limited to one or two trading assets. You can trade currencies, cryptos, indices, futures, commodities, shares, ETFs, and stocks.
This makes trading CFDs flexible as it offers traders a lot of choices.
The wide range of trading instruments also allows traders to diversify their trading portfolio.
Risk management features
CFD brokers offer certain risk management features to traders such as stop-loss orders and take-profits.
Stop-losses stop your positions once it reaches a certain price level. If you are going short, your stop loss order will be at a higher level than your current selling price.
If you are going long, your stop-order price should be lower than your buying price.
These tools minimize risks and are extremely helpful for new traders.
They also limit your potential profits as you’re stopping your position prematurely.
CFDs as a hedging tool
CFDs can be used as a hedging tool for risk minimization. As discussed before, you can trade CFDs by going long or short.
If you hold a long position and you think you may lose money from it, you can open a short position to counteract those losses.
This process of opening a trade in the opposite direction is called hedging. Just like take-profit orders, hedging minimizes your risk but also decreases the overall profit potential.
No stamp duty or hidden fees
CFDs don’t have any stamp duty on them. This is because you don’t own the underlying CFD asset.
There are no hidden charges on trading CFDs as well. The common charges in CFD trading are the spread, rollover fee, and commission charges (only applies for shares).
How Does CFD Trading Work?
Now that we have seen what CFDs are what its features are, we can see how CFDs work. We will explain in-depth how CFD trading works with the help of examples.
So basically, CFD is a contract or an agreement between the buyer and the seller. The trading happens over the counter in trading platforms offered by brokers.
When a trader wants to open a buy position, the brokers act as sellers and when traders want to sell, the brokers act as buyers. They act as counter party to traders.
The trading platform will list all the CFD assets under their portfolio. A trader chooses his preferred asset to trade.
There are multiple CFD assets traders can invest in such as stocks, shares, cryptos, commodities, indices, currencies, and much more.
After he makes his choice, he places a request to trade that underlying asset.
The request involves selecting the number of units of that asset, a stop-loss order/ take profit order, and finally choosing ‘buy’ or ‘sell’ position on that asset.
His trade size depends on his experience, willingness to take risks and capital.
After completing all the required necessities, his order will be placed and his trade starts from there until he chooses to close his position.
Let’s understand this whole process with the help of examples.
How Does CFD Trading Work: A Winning Example
Example 1: Consider a broker ‘XYZ’. This broker has its own proprietary CFD trading platform through which traders can trade CFDs.
Consider a trader named Mark who wishes to trade in CFD stocks. He wishes to trade stocks of ‘ABC’ corporation. Each stock has a market buy price of $20.
Mark anticipates there will price of ABC’s stock will rise in the next few days so he decides to open a long position on 50 of ABC’s stocks.
The total cost of the transaction amounts to $1000. The margin for the asset is set at 5% which means he only has to pay $50 to open his position.
You now realize how attractive and convenient CFDs are. Mark is able to trade $1000 of CFDs by investing only $50.
In other words, his leverage ratio is 20:1. This is a high leverage ratio so he has to be careful or else his losses will be magnified too.
The following day, ABC’s stock price rises to $22 so Mark’s prediction was right. Mark is satisfied with the price rise and decides to close his position by going short on his stocks.
This would mean he would earn $100 ($2 x 50) in profits. Mark is a smart and successful trader who knows how much leverage he can handle, which assets he’s acquainted with and when to close in a trade.
This is why he ends up with a profit.
How Does CFD Trading Work: A Losing Example
Example 2: Consider another CFD trader Peter, who is planning to invest in shares of AAA Corporation.
The shares are currently worth $200 when selling and $200.10 when buying.
Peter anticipates the price of these shares will drop so goes for a short position. He decides to purchase 50 of these shares. In this case, the margin is set at 3% so he has to deposit 3% of $10000 ($200 x 50) which comes to $300. The leverage ratio (33:1) is very high in this case.
Unfortunately for Peter, things didn’t go as planned and the market price went opposite to his position, i.e. the price of the asset suddenly rose to $207.
In panic, he closes his trade to avoid further losses. This means he lost $7 per share which makes his total loss amount to $350.
In short, Peter lost more he invested. This is what makes leverage a double-edged sword.
You can either gain money quickly or lose it all.
What Peter should have done to minimize his risk was add a stop-loss order. The stop-loss order would’ve closed his trade after reaching a certain price.
Let’s learn from Peter’s mistake and adopt security measures when placing a trade.
In the above two examples, we took a look at two traders, Mark and Peter.
One gained profits by taking the right decisions and other lost money on his trades. This is how CFDs work.
You need to understand the market behavior and accurately predict in which direction it is going to head to.
There’s a reason why 75-80% of CFD traders lose money. The CFD market is very volatile and unpredictable.
You may not be successful every time but an informed decision is much better than guessing.
CFD Trading Platform
Since all the CFD trading happens through a trading platform, we will take a look at it is and what its features are.
Trading platforms are software that a broker provides to its users (traders and investors) where they can manage trade positions by opening and closing them and also add risk management features.
It is a complete interface that caters to all trading needs. There are real-time price feeds, analytical charts and tools, indicators, expert advisors, trade history, and much more.
All the features work seamlessly to offer traders a rich trading experience.
In a CFD trading platform, you get access to various features that will facilitate trading for you.
Firstly, to monitor the price movement, there is a live trading chart. Here, the live price of the asset is displayed with respect to time.
The time frame can be adjusted depending on the duration of your trade.
To perform technical analysis, you will be provided with tools like indicators and graphical tools.
These will help you predict the way the market will move.
You have to select your asset from the asset index. All the assets offered by the broker will be displayed there categorically.
Next, you have the area where you have to place your trade. Here, you will enter your trade amount, your preferred leverage, and additional risk management such as stop-loss and take-profits.
Finally, you will choose to buy or sell the asset. These are the very basic components of a trading platform.
In addition to this, brokers offer more features nowadays such as portfolio overview, trade history, contact support, market news, sentiment analysis, education, and much more.
In the next section, we will take a look at the various criteria that are vital to be present in a trading platform.
How To Choose A Good Trading Platform?
There are certain features and characteristics that you have to look for before settling down on a trading platform.
Make sure the broker you choose and the platform they provide have these features. We listed them here:
Reliability
This is the first factor to look for in a trading platform.
The trading platform must be reliable in its execution of orders.
There must be zero-delay in placing orders on a consistent basis. Reliability should also come in the form of trust and reputation.
Don’t go for a broker that has been around for only for a few months. The broker that provides the trading platform must be regulated and licensed.
Deposits and withdrawal requests must be processed without any errors. Also, ensure that the broker that provides this platform is regulated and monitored by financial governing bodies.
Easy user interface
The user interface is where the user gets to access all the features of the trading platform.
Even if the platform has all the features that traders want, if it isn’t easy to use or disorganized, users will feel discouraged to use it.
A good trading platform should have an intuitive user interface which makes placing trades and managing positions easy.
If they provide a mobile app, then it should resemble the desktop app and offer the same layout and features to maintain the same satisfaction level for traders.
Feature-rich platform
Along with the easiness of use, a trading platform must have all the features necessary for efficient trading.
Live market feeds, different chart types, trends, indicators, scripts, and expert advisors are some of the must-have features for any trading platform.
Like mentioned above, features like market sentiment, multi-charts, tournaments, market news, video tutorials, trading history are always desired by traders.
Demo Account
Make sure the broker provides a demo account. A demo account involves transactions using virtual money.
This makes it useful for new traders to practice trading and experienced traders to practice different trading strategies.
All the real market conditions are replicated in the demo and thus you get real trading experience without the element of risk.
You can practice trading different assets with the hope of diversifying your portfolio in a demo account.
The confidence boost you get from trading in a demo account will carry over to your real trading.
Educational resources
A trading platform must offer educational resources on its platform, and trading in general.
These resources can contain tips and tricks on trading in general or it can be useful tutorials on using their platform.
For instance, a CFD trading platform should contain tutorials on CFD trading and its various aspects.
Having these materials embedded in the platform is helpful for traders where they can refer for help instantly.
Security
All kinds of security must be provided by a CFD trading platform. The transaction information is usually encrypted using encryption technology like SSL.
The personal information provided by clients must be secured and only visible to the broker and the client.
To access the trading platform, there must be strong credentials and these must be encrypted to avoid falling into the wrong hands.
Based on these factors, you can find the best CFD brokers in our comparison table.
Conclusion
We hope after reading this article, you have a clear understanding of how trading CFDs work.
We explained its definition, features, and explained its functioning with the help of two examples.
CFD trading takes place in a trading platform and we explained its definition and the features a good platform must possess.
CFDs are risky, leveraged assets so you have to be careful with your investment before trading. Research and educate yourself first and start by trading small.
Our CFD education section covers all kinds of useful information on CFD trading. Feel free to check them out for a better understanding of CFDs.
