What is CFD Trading? Contract For Difference (CFDs) Meaning & Explanation
If you are interested in trading CFDs, you must understand what are CFDs and what CFD trading is.
They gained rapid popularity ever since its introduction in the 1990’s. Currently, they are one of the most popular forms of online trading.
We’ll explain the definition and the various features of Contracts for difference in this article.
This article intended for newbie traders or traders who haven’t started CFD trading yet.
A complete beginners approach has been taken to ensure new traders completely grasp the concept of CFD trading starting from the meaning of CFDs.
Contract For Difference Definition
CFDs stand for Contracts for Difference. What are contracts for difference? It is a contract that a buyer and seller form between them.
At the end of the contract, the traders exchange the difference between the opening and closing price of the asset.
If the change is positive, the seller pays the buyer the difference and vice versa when the difference is negative.
They are financial derivatives which mean you don’t own the asset which you trade. Instead, you speculate or predict the price movement of the CFD asset.
We will take a detailed look at the features of CFD below. We will also take a look at its advantages and disadvantages.
What Is CFD Trading?
Essentially, when you trade using CFD contracts, you are carrying out CFD trading. CFD assets consists of stocks, indices, cryptos, currencies, commodities, and much more.
CFD trading takes place through a decentralized trading platform which is usually a trading platform offered by brokers.
The CFD brokers act as an intermediary between you and the market. Through various fees and commissions, brokers earn money.
There are two prices that quoted in CFD trading: the buy (ask) price and the sell (bid) price.
The price, at which you open a short position, i.e. selling the asset, is the sell price.
The price, at which you open a long position, i.e. buying the asset, is the buy price.
The buy price is always slightly higher than the sell price. Spread is the difference between these two prices.
No owning of the asset takes place under CFD trading. The traders bet on the price movements of the assets and either make a profit or a loss.
To open a position, you pay a margin which is a percentage of the total transaction cost.
The trading takes place in an online CFD trading platform provided the broker.
Example Of A CFD Trade
You decide to invest in CFD stocks. After a thorough market analysis, you choose your preferred stock.
You decide to buy 100 CFD stocks of that company, each priced at $20.
You choose to open a buy position because you expect the price of the stock to rise. The margin for the trade is 5%.
So you pay 5% of the total transaction cost which comes to $100 (0.05 x $20 x 100). Next week, the price rises to $25 and that’s a good enough price for you to close your trade.
Thus by investing $100, you are earning a profit of $400!
Now let’s see what happens when the situation is reversed.
You set a stop loss at $18 in case the market moved in the opposite direction.
Now, the price has fallen below $20, and the stop loss is triggered at $18. The result of this trade is you would’ve made a loss of $200 ($2000- $1800).
Whether you gain or lose money depends on your market prediction. This requires a good knowledge of the market and lots of experience.
Features Of CFDs
CFD’s have some unique features that make it different from other forms of trading.
Traders can enjoy leverage and marginalized trading, they not required to own these underlying CFD assets, and they can trade in both directions.
We will explain the the different features of CFD here:
Lack of Ownership
You don’t own the assets in CFD. CFDs duplicate the market movements and pricing of that asset.
To open a CFD position, you pay an initial deposit called margin. When you buy a stock, you buy a small portion of the company.
When you buy CFD’s of a company, you have no ownership of the company.
The only thing owned is the contract between the buyer and the seller.
Hence any benefits or losses arising from ownership shouldn’t concern CFD traders.
Long and Short trading
You can go both long and short with CFDs. When you expect the price of a CFD asset to rise, you buy. Hence, you open a long position in the CFD market.
When you expect the price of the asset to drop, you sell it. This is going short with CFDs.
Consider the example of an imaginary company XYZ. The value of each XYZ stock is worth $65.
You speculate that its price will increase in the following weeks. You open a long position by purchasing 100 stocks.
The total price comes to $6500. Your prediction turns correct and next week the price rises to $67.
You decide to close your position after this. You make a profit of $200 in the process.
If your prediction was wrong, you would’ve made a loss. This flexibility of going long or short makes CFDs a useful way of trading.
Keep in mind there are certain differences in costs and fees between long and short. You pay interest on a long position.
A short position earns you interest. Brokers determine the interest rate.
The amount of interest is a product of the daily closing value of the CFD asset and interest rate.
In the case of dividends, holding a long position earns you dividends while you pay the dividend amount to the broker if you go short.
Margin and Leverage
You don’t need to pay the full price of the asset you are trading in. CFDs are traded on margin.
That means you pay a small amount to open a larger position. This small deposit is margin.
And the ability to trade large positions using a small margin is leverage. This is why we say CFDs are leveraged.
CFD’s differ from stock trading in this regard. In the case of stocks, you pay the full price to buy a stock.
The broker sets the margin level. Also, different CFD assets have different margins.
To calculate your margin amount, you need to know how many CFD units you are trading, price of each unit, and the margin percentage.
Let’s say you buy 50 shares of ABC Corporation where each share is priced at $1. The margin offered is 5%.
Your margin amount equals $2.5 (50 x 1 x 5% = $2.5). This means you are opening a CFD position worth $50 using only $2.5.
The leverage ratio is 20:1 on the asset. You are trading shares worth 20 times your investment.
You can now realize how profitable CFD trading is. A small investment can earn you large profits.
At the same time, if the position moves against you, your losses will be magnified as well.
Leverage can be both a boon and a curse. The risks involved are high and you can end up losing more than you invested.
Expiry Date
CFD’s don’t have any fixed expiry dates on them. They are traded on margins and depending on the position you pay or receive an interest amount.
The trader pays interest at the end of each trading day. A trader can choose to close or continue in his position.
This position can continue as long as he wants. There is no expiry on it.
There are certain exceptions to this rule. Certain CFDs do have an expiry on them. Bonds, futures, energy, and copper CFDs have a specific expiry. They expire monthly or quarterly.
Multiple Trading Instruments
CFDs aren’t limited to one or two markets.
You can trade CFDs using shares, stocks, commodities, indices and even currencies.
Brokers offer over 1000’s of financial instruments all over the globe.
This feature of CFD allows traders to have flexibility and variety in their trading.
Traders also get to diversify their trading portfolio when trading CFDs.
Stop-Loss Order
Another useful feature of CFDs is stop-loss orders. They are used to control risks and to reduce losses.
Brokers provide stop-loss and guaranteed stop loss orders in case your position goes against the market flow.
Consider the following situation: You speculate the price of an asset to rise and buy CFD contracts.
But the price drops and you start losing money. If you set a stop-loss order, you can limit your loss.
For example, if the current price is at $400 and you set a stop loss at $370, your broker stops your position if the price drops below $370.
This protects traders from huge losses. Imagine, if there wasn’t a stop-order placed and the price kept dropping, the losses would be irrecoverable for many traders.
Trading Fees
There are certain fees associated with CFD trading:
Spread: It is the difference between the buying and selling price of an asset. The buying price is usually higher than the selling price.
Traders prefer tight spreads as the cost decreases as spread decreases.
Commission: Commission charges only apply to share CFDs. The charge lies from 0.1% to 0.25%, depending on your broker.
Overnight fee: This fee is charged or provided at the end of each trading day. It is an interest payment to cover your leverage for the asset you’re holding.
Hedging
You can use your CFDs for hedging as a security measure.
You open a long position by buying shares as you expect the price to rise.
Due to volatile market conditions, the price drops and now you suffer loss.
To counteract this loss, you open a short position and earn some profits from there.
This process of reducing losses is hedging. Sometimes, even before the market position moves against you, you can hedge your assets to avoid future losses.
There are certain disadvantages of hedging as well.
By opening a position opposite to your original position, you are sacrificing your overall profit.
If the price of CFD assets didn’t drop at all and rose, you lose potential profits.
Another problem of utilizing hedging in CFD markets is the fast-moving nature of CFDs.
Prices fluctuate a lot and it may be difficult to keep track and hedge accordingly.
Why Should You Trade CFDs? (Advantages Of CFD)
In order to trade CFDs efficiently, you need to know the advantages it has to offer. Hence, in this section, we will discuss the various benefits of trading CFDs.
Marginal investment
CFDs are leveraged products. You only pay a margin to get started.
This encourages new traders to try out trading CFDs. They are only exposed to a fraction of the transaction. This makes it easy to recover from losses.
Leveraged returns
This is the most lucrative feature of CFD traders. By investing a small margin, you are betting on large portfolios. Over a short period of time, you can earn huge profits.
You can realize the power of leverage when you invest $10 and get $4000 in return (400:1 leverage ratio).
No stamp duty
CFDs don’t require you to pay stamp duty as you don’t own the asset you trade. Lack of hidden fees or taxes is a big advantage for trading CFDs.
Stamp duty exemption is one of the many salient features enjoyed by CFD traders.
No expiry date
CFDs don’t expire. They last as long as you keep your position open.
You can keep earning profits on your position without any worry for the time limit.
However, for every day the position is kept open, an overnight fee is incurred.
Variety of financial instruments
You can choose from tens of thousands of CFD assets to trade.
Unlike Forex trading, which is only limited to currencies, CFDs can be traded in almost all financial goods.
You can even trade forex pairs as CFD.
Profit from both rising and falling prices
You can make money by going both long and short on CFD assets.
When the price increases, you go long. When the price falls, you go short.
As a result of this, you can hedge your assets to protect your profits or minimize losses.
Why Shouldn't You Trade CFDs? (Disadvantages Of CFD)
We’ve heard of all these risks associated with CFD trading. Then the question might arise why trade CFDs?
Why not go for a safer alternative. Well, there are certain disadvantages of CFD trading.
We will discuss these in this section.
High risk due to leverage:
The biggest advantage of trading CFDs is also is the biggest drawback. This is due to leverage.
Leverage can make you rich overnight, or zero your investment. Leverage can magnify your losses.
You may end up losing more than you started with. For beginner traders, we recommend to start with a low leverage ratio.
Not suitable for long-term traders:
The CFD market changes rapidly and is hard to predict. Long-term investors face two issues in CFD trading: increased costs and subsequent increase in risk.
Positions that are continued at the end of the trading day face an overnight charge.
Hence for long-term positions, it can get quite expensive.
No ownership benefits:
As discussed before, CFD traders don’t own the underlying asset.
They speculate on the price change of the asset. This makes it different from buying shares or stocks.
When you buy a share, you own a fraction of the company the share belongs to.
In the case of CFDs, you have no direct involvement with the company. You don’t have any ownership nor do you take part in company decisions.
Risk of overtrading:
CFDs have low investment costs and market fees. They can also be accessed easily thanks to its multi-platform availability.
However, this can be a problem as it leads to overtrading. Beginner traders must avoid overtrading at all costs as it can lead to huge financial losses.
Requires in-depth knowledge of the market
To be successful in CFD trading, you need an accurate prediction of the market flow. The prediction doesn’t come from guesswork or taking a chance.
It requires a deep understanding of the way the market works and taking calculated decisions.
Big CFD traders use advanced mathematics equations and graphs to make a prediction.
Beginner traders find it daunting to make decisions simply because they lack enough knowledge or experience.
Constant monitoring:
You cannot open a CFD position and forget about it. Off course, you need to constantly monitor your trade as the market is volatile.
Also, you need to invest a lot of time behind it and this may not be everyone’s cup of tea.
This applies to short-term traders especially where even small changes need to be observed carefully.
Popular Instruments in CFD Trading
There are many options to choose from when trading CFD’s. The three most widely-used and popular CFD assets are currencies, commodities, and indices.
Trading Currencies As CFDs
CFDs can be traded on Forex. This means you can CFD trade on currency pairs.
For example, you can speculate on ‘EURUSD’ currency pair. If you think the price of Euro will fall against the US dollar, you will go short and sell your shares on this pair.
The opposite is true if you think the price of the euro will rise compared to the dollar. You will purchase more CFDs of this pair.
The popular currency pair includes EURUSD, GBPUSD, USDCAD, USDJPY and many others.
Trading Commodities As CFDs
Commodities like metals (gold, copper, silver etc.), natural resources (natural gas, crude oil) and agricultural items (livestock, crops, sugar etc.) can be traded as CFDs.
The prices of commodities fluctuate every day. So short-term CFD trading is viable for commodities.
One thing to keep in mind is that CFDs don’t have any expiry on them.
But commodities have a fixed expiry date on them.
Another thing to keep in mind is that Commodities are priced in US dollars. Any change in the dollar rate affects the price of the commodity.
Trading Indices As CFDs
Indices are a standard of market performance. Traders can trade on these indices which contains a group of shares of companies that are similar.
Index CFDs don’t have any commission fee on them. Popular CFD indices you can trade are:
- Nasdaq
- Dow Jones
- FTSE
- S&P 500
The Costs Associated With CFD Trading
The various costs related to CFD trading are listed below:
Spread
CFD brokers quote two prices for an asset. Bid price and offer price.
The bid price is the price where you go short on your CFDs i.e. you sell them.
The offer price is the price where you go long i.e. you buy the asset. Spread is the difference between the bid price and the offer price.
Brokers try to maintain a competitive spread as tighter spreads make it easier and quicker for traders to make profits.
Commission fee:
Trading CFDs are generally free of commission charges.
But when it comes to trading CFD shares, you are subjected to a commission fee.
This fee depends on the overall cost of trade. Brokers usually charge a commission fee in the range of 0.1% to 0.25%.
Different regions have different commission charges.
Overnight Financing:
CFDs that are kept open at the end of the trading day are eligible for a charge called overnight financing.
These are charged on CFDs that don’t have any expiry date on them.
This charge covers the cost of the leverage that you maintain overnight. Therefore, for long-term trading, it can get quite expensive.
In the case of holding a short position, you are eligible to receive this charge.
Guaranteed Stop Loss Order costs:
There is no charge for using a regular stop order loss. But in the case of using a guaranteed stop order loss, brokers charge a premium fee.
GSLO guarantees closing your position at the price you requested. This stop happens regardless of market gaps.
Who Is CFD Trading Suitable For?
Anyone with the capital to invest can jump into CFD trading, but not everyone can be successful.
Or it may not suit everyone’s preferences. However, it may be optimal for the following people:
Experienced traders
CFDs are risky assets to deal with. Without proper knowledge of the market and enough experience, it will be hard to make consistent profits.
You may get lucky every once in a while. But if you’re looking to optimize your investments, choose a less risky form of trade or try a demo account first.
That being said, it doesn’t mean beginner traders can’t indulge in CFD trading. With proper
Short-term traders
If you’re someone who wants to invest in an asset and forget about it, then trading CFDs isn’t for you.
CFDs need to be monitored regularly and you need to invest a lot of time watching the market flow.
Long-term trading gets costly over the time and risk increases along with it.
If you prefer trading over assets that last a day or two then CFD trading may be ideal for you.
Prefers a wide range of instruments
You can trade tens of thousands of global instruments with CFDs.
We previously discussed how you can trade commodities, currencies, indices, stocks, shares etc. with CFDs.
Many traders prefer CFD trading over other forms of trading due to the versatility that it offers.
Flexible trading position
CFDs don’t have any expiry on them. They last as long as you keep your position open.
If you continue making profits by running a long position, then keep doing it.
If you realize you’re making losses, then you can stop it.
You can also hedge your existing position if your position goes against the market direction.
Emotionally stable
CFDs are leveraged products. You can make a huge profit or lose a lot of money quickly.
Dealing with a lot of money over a short period of time may not be ideal for someone driven by emotions.
If you are patient and can deal with losses without losing your mind, CFD trading is for you.
Leveraged trading always carries an element of risk. Hence you should be willing to take these risks or keep your leverage ratio altogether.
How To Trade CFDs
It is very easy to trade CFDs online. Within a few minutes, you can get the whole process up and running.
Here is a step-by-step guide on how to get started on trading CFDs.
This is the first step to trading CFDs. There are thousands of CFD brokers nowadays offering competitive trading platforms.
So choosing the right one for you can be a daunting task. However, there are certain criteria to look for when selecting a broker. We will list them in brief:
- Regulation: A regulated broker is a must have for any broker. Once such regulatory body for CFD brokers is the FCA (Financial Conduct Authority). They provide authorization to brokers to conduct CFD trading.
- Initial deposit: Brokers charge you to fund your account with a minimum fee. The charge lies from $10 to even $1000. Select the one that offers a low deposit fee.
- Variety of instruments: Select a broker that offers a wide variety of CFD assets to choose from.
- Ease of usage: Their trading platform should feel easy to use. Also see if they offer multiple platforms such as web, mobile, and
- Demo account: Make sure your broker offers a demo account. You can practice your online CFD trading in a demo account before switching to live trading.
Create a CFD account from the broker you just chose. If you feel you lack the confidence or experience to start live trading, you can open a demo account.
This is totally up to you. But for beginner traders, we would recommend that you do.
Explore the CFD market. There will be thousands of trades to choose from.
Some brokers offer recommendations while others don’t. If your broker doesn’t offer one, you shouldn’t worry. Just choose a market you’re most familiar with.
The more exposure you have to the market, the better. You can choose from indices, shares, stocks, currencies, cryptocurrencies, and commodities.
To start a trade, you must open a position in the CFD market. To do this, you either go long (buy) or short (sell).
Go long when you expect the price of the asset to rise. You make profits from rising prices. Go short when you expect the price of the asset to fall.
So you make profits even from falling prices. Keep in mind that the buy price and the selling price of the asset are different.
The buy price is always higher than the selling price. The difference between these two prices is called spread.
Choose how many units of assets you want to trade. One point in the price movement equals the cost of one CFD.
If you’re confident in making profits from your position, you can increase your trade size.
For beginner traders, we would recommend keeping your trade size low. It will be easy to recover from losses.
Brokers provide stop order as a protective measure. It limits your losses in case the market moves against your position rapidly.
Your broker will close your position once the market price drops to your stop order price.
Sometimes, due to market volatility, your stop order may not be executed properly. You may lose money as a result.
Guaranteed stop order ensures the stop orders are placed at your requested price. This type of guaranteed stop comes at a premium price.
You cannot open a CFD position and forget about it. CFDs require constant monitoring. The market is volatile and changes often.
So keep a close eye on your trade position.
Once the market moves in the opposite direction, you can close your trade. If you were in a long position, you go short to close.
Once your position is closed, your net profit/loss will be calculated and deposited in your account. You can withdraw these funds later.
Conclusion
To summarize, CFDs are financial leveraged products.
Traders don’t own the underlying instrument and instead bet on its price movements. Hence, you can profit from the asset without even owning it.
To open a CFD position, you pay a deposit. This deposit is known as the margin. CFDs don’t have any fixed expiry on them.
Traders can maintain a position as long as they like. You can trade thousands of global assets in CFDs.
To minimize your loss or to guarantee profits, you can use stop-loss orders provided by brokers.
You can also use hedging to counteract your losses.
Some popular CFD instruments include commodities, currencies, and indices.
CFD trading may not be suitable for everyone. Generally, experienced and short-term traders prefer CFD trading.
You also have to be emotionally stable and have the patience to succeed in CFD trading.
This form of trading offers a lot of flexibility to traders. If you haven’t tried CFD trading yet, you can give it a try with the help of a demo account.
Our education articles on CFD will assist you in your trading.
