What is CFD trading — how does it work?

Key takeaways

• A contract for difference (CFD) is an agreement to exchange the difference in value of a financial instrument between the opening and closing price of the contract.
• A CFD trader never truly owns the underlying asset; they only speculate on the price movement of an underlying asset.
• A profit or loss occurs depending on the fluctuation of the asset’s price movement.
• CFDs provide access to underlying assets at a cheaper cost than buying the asset directly due to CFDs offering the opportunity to trade with margin.
• CFD trading is also a leveraged product.
• With CFDs, traders can open long (buy) and short (sell) positions, allowing them to trade both bull and bear markets.

What is CFD trading?

Contract for differences (CFDs) is a derivative product similar to spread betting, where a trader speculates on the price movement of various financial instruments, such as stocks, bonds, forex, commodities, and indices.

With CFDs, traders have the option to open a position in either rising or falling markets. 

If a trader predicts the market will rise, they could open a long (buy) position, or if they believe the market will fall, they could open a short (sell) position.

Unlike traditional investing, where traders and investors take ownership of financial assets, with CFD trading, they don’t take ownership of any underlying assets, which in some jurisdictions can involve certain tax benefits.

It might also be essential to remember that, unlike options or forwards, CFDs don’t have a fixed expiry date. 

Instead, a CFD trade is closed once the trader opens a trade in the opposite direction to the one they have already opened. So, if they have a long (buy) position open on an asset, they would need to open a short (sell) position to close the trade.

A fee is payable when a trader decides to keep a trade open overnight, but more on that later.

How does CFD trading work?

A CFD in trading is a contract of agreement established between a trader and the CFD broker to settle the difference in price for the underlying asset from when the trade is opened to when it’s closed.

Traders buy or sell several units (also called contracts) from their chosen financial instrument, which is linked to an underlying asset. Unlike traditional trading, CFD trading does not involve taking ownership of the underlying asset.

As previously mentioned, CFDs are a form of derivative trading that allows traders to open a long (buy) position if they believe the market will continue to rise or a short (sell) position if they believe the market will fall.

There will always be two prices shown on a trading platform with CFDs. These two prices are the ask (buy) price; this is the price traders will use to open a long position. 

Then, the bid (sell) price is the price traders will use when they might want to open a short position.

The ask (buy) price will always be slightly higher than the bid (sell) price. The difference between these two prices is what’s known as the spread.

Some brokers may charge a commission to open and close a trade, while others will have wider spreads to compensate for not charging a commission fee. Either way, the spread will always be present.

The way profits and losses are calculated with CFD trading is determined by the number of points (or pips) the market moves in a trader’s desired direction, correlated by the number of units they might’ve bought or sold.

As CFD trading is a derivative product, trading is also done through the use of leverage. A trader could open a bigger position size with a small amount of capital, called margin. This could also be referred to as leveraged trading, which we’ll discuss in more detail below.

Trading CFDs with margin and leverage

Leverage enables traders to control larger positions by depositing only a fraction of the total trade value, known as margin. For example, with 20:1 leverage, a trader could manage $20,000 worth of an asset with just $1,000. This amplifies both potential profits and losses since gains and losses are calculated on the full position size, not just the margin.

The initial margin is the amount required to open a position, the free margin represents available funds for new trades, and the maintenance margin is the minimum equity needed to keep trades open.

Falling below the maintenance margin can trigger a margin call, which means that additional funds must be added; otherwise, the broker can go forth and choose which open trades they want to close automatically in order to prevent the trader’s account from falling to zero.

Because leverage increases risk, small adverse market moves could quickly reduce a trader’s margin and lead to losses exceeding their deposit. Regulated brokers offer risk management tools such as negative balance protection and clear leverage limits. Understanding how leverage works and applying strict risk and money management are essential for trading responsibly.

Before a broker allows a trader to use margin, they might want to gather more information, such as their identity and ability to cover potential losses.

To gain some experience, novice traders could start with a demo account before moving to a live account. When opening a live account, a trader must also ensure they have the necessary funds to start trading.

Sometimes, brokers require new traders to answer questions to test their knowledge and ensure they understand the risks involved with margin trading. It might be best to learn how trading with leverage and margin works first.

CFD trading examples

Now that we’ve covered some of the necessary details regarding CFDs and how they work, it’s time to look at some examples to give you a better understanding from a market perspective.

The first example we’ll look at will be for a bull market, and the second one for a bear market.

Going long (buy)

Let’s say a trader is looking to buy (go long) Google shares because they believe the market will continue to rise in value.

They buy 10 CFDs of Google shares at $100 a share, which gives them a total value of $1000. Each CFD is equal to a $1 move in Google’s share price. If the share price rises to $110 per share, they would’ve made a profit of $100.

To calculate the amount, a trader multiplies the number of CFD units bought by the amount the share price rose in value ($10 x 10 CFDs).

The profits made exclude any fees or commissions issued by a broker.

Going short (sell)

Suppose a trader looks at Google and predicts the price will fall. They open a short (sell) position by selling 10 CFD units on Google at $100 per share. Again, let’s assume that each CFD equals a $1 move in Google’s share price.

The share price declines towards $90, giving them a profit of $100. The profits for a short position are calculated the same way as for a long position: the number of CFDs sold is multiplied by the amount the market price moved ($10 x 10 CFDs).

Again, the profits gained exclude any fees and commissions a broker issues.

It might be best to remember that if the market moves against the trader’s prediction, either in a long or short position, they will suffer a loss on their trade.

What assets can be traded through CFDs?

CFD trading offers traders a wide variety of financial instruments to trade. Some of these instruments include:

• Forex: EUR/USD, GBP/USD, USD/JPY, EUR/GBP, and more.
• Commodities: Gold, silver, oil, and more.
• Stocks: Google, Microsoft, Apple, Vodafone, and more.
• Indices: S&P 500, Dow Jones, DAX 40, FTESE 100, and more.

Other markets are also available for traders to participate in, such as options, bonds, and interest rates.

Different CFD trading strategies

Exploring different CFD trading strategies could help traders manage risk and identify potential opportunities when trading CFDs. Depending on their trading style, time availability, and market conditions, some strategies might suit them better than others. Whether they prefer quick trades or longer holds, there are various approaches they could consider, each with its own benefits and factors to weigh.

• Trend Trading: Follows the market’s overall direction, holding positions while the trend persists.
• Swing Trading: Targets short- to medium-term price moves by entering during retracements or reversals within a trend.
• Day Trading: Involves opening and closing trades within the same day to avoid overnight risk and capture intraday price swings.
• Scalping: A very short-term approach focusing on small price changes through frequent trades.
• Hedging: Uses CFDs to offset potential losses in other positions, helping reduce portfolio risk in uncertain markets.
• Breakout Trading: This strategy involves entering trades when the price breaks key support or resistance levels, expecting strong momentum to follow.
• Range Trading: Involves buying at support and selling at resistance when the price moves within a sideways range, anticipating the pattern to hold.

What are the costs for CFD trading?

There are three different costs involved with CFD trading, which traders might want to consider while trading. Let’s go over these three costs in more detail to give you a better understanding of what to look out for.

1. The first cost is the spread. As previously mentioned, the spread is the difference between an asset’s ask (buy) price and the bid (sell) price. The spread is paid automatically every time a trade is opened, whether it’s a long or short position. Even though spreads are generally minimal, it might still be worth comparing spreads from different brokers.
2. The second cost is commission; while some brokers state they are commission-free, this is usually compensated by a wider spread. At Trade Nation, we don’t charge commission fees and offer low-fixed spreads. That said, if a broker does charge a commission fee, it will usually appear as a percentage of the asset’s value. Commissions are generally charged for opening and closing a trade.
3. The last of the three costs involves overnight fees. These fees are applicable if a trader decides to keep their trades open for longer than a day. These rates will usually be a set fee issued by the broker. In some cases, a trader can earn interest on the value of their trades depending on the position they have open and the direction of the market.

CFD trading vs spread betting

Spread betting is also a derivative product like CFDs, enabling a trader to buy or sell various financial assets from various financial instruments using leverage. However, there are some differences between CFD trading and spread betting.

With spread betting, a trader doesn’t buy or sell contracts; instead, they place a bet with a number of pounds per point on the direction they predict the market will move. They will profit from every point the market moves in their predicted direction.

However, for every point the market moves against them, they will make a loss.

Advantages of CFD trading

Let’s look at some of the various benefits offered through trading CFDs.

Market availability

CFDs are derivative products, which means their prices are derived from financial instruments in the underlying market. This allows traders to speculate on the price movements of various financial instruments through CFD trading.

Some of the more popular instruments include forex, indices, stocks, bonds, commodities, and more.

That said, traders could use CFD trading to diversify their portfolios and gain access to these financial instruments.

Ability to go long and short

As mentioned before, traders have the option to open both long (buy) and short (sell) positions. The advantage here is more in the ability to open short (sell) positions because, although possible, it’s difficult to make short trades in traditional investing.

This makes the ability to go short (sell) when the market falls quite appealing to traders.

Leverage and margin

Leverage allows traders to open a bigger position with just a fraction of the amount required by depositing a small amount of capital into their account, called margin.

Trading with leverage through margin can magnify a trader’s potential profits if the market moves in their desired direction. This is because profits are calculated based on the total value of the position size and not just the margin required to open the position.

Trading hours

Traders are able to trade the market hours for all popular financial instruments. The market trading hours for these financial instruments include the following:

• Indices: The indices market is open 24 hours a day, five days a week.
• Forex: The forex market is also open 24 hours a day, five days a week.
• Commodities: Commodities are also available 24 hours a day, five days a week.
• Stocks: Stocks are available to trade only during the times of the stock exchange they’re listed on. For example, stocks from American companies listed on the New York Stock Exchange are only available to trade during the New York Stock Exchange’s open hours.

It doesn’t matter where you are in the world; there is always more than one market open where traders can participate.

Hedging

Traders and investors could incorporate hedging into their strategy to offset potential losses in their existing portfolios. Hedging works by opening a position opposite to the one in a trader’s portfolio.

For example, let’s say a trader has a long position open on Google in their main portfolio, and they see the market is starting to decline. 

They could then open a short position on Google through CFDs, which would enable them to offset any losses they might sustain from Google’s price decline.

Disadvantages of CFD trading

Now that we’ve covered the various advantages of CFD trading, let’s look at some disadvantages.

Risk

CFD trading is a fast-paced environment, and risks are involved, like any other form of trading. 

One of the biggest risks when trading CFDs is losses to a trader’s account. These losses occur when the market starts moving against their desired prediction.

Because CFD trading is done through leverage, it is possible to lose more than the initial margin amount required to open a trade. This is because with leverage, profits and losses are calculated based on the total value of the trade, not just the margin amount.

As mentioned above, leverage trading could magnify potential profits, but on the other hand, it could also magnify potential losses. That’s why it’s both an advantage and a disadvantage for traders.

When a trader’s account sustains consecutive losses, a margin call notification might be sent out stating that additional funds must be added to the account. If this is not corrected, the broker could automatically close all open trades.

Paying the spread

When entering a trade, paying the spread might seem like a minor disadvantage for traders with a big account. However, this could be daunting for traders with smaller accounts as it could limit any potential profits.

Some brokers don’t charge commissions on opening and closing trades, but could have a wider spread. This could impact a trader’s potential profits even more, as they would need to pay a bigger spread when opening a trade.

Weak industry regulations

CFD trading regulations will vary depending on the trader’s jurisdiction. Some jurisdictions will impose restrictions granted by financial authorities on various aspects of CFD trading, such as the amount of leverage available to traders.

With the industry not being highly regulated, the credibility of CFD brokers is mainly dependent on reputation, financial position, as well as longevity. That said, it might be best to first do some due diligence on a broker before opening an account.

Risk management in CFD trading

As previously mentioned, CFD trading, as with any form of trading, presents some risks that might need to be considered. For this reason, having a solid risk management strategy plays a crucial part in any trading strategy, as it could help limit any potential losses a trader might sustain.

Before a trader starts trading with CFDs, there are a couple of factors they might want to consider first, such as deciding which markets they wish to trade. This is because every market has its own level of volatility and liquidity, which could impact their trades.

After deciding which markets to trade, traders might want to set up a trading strategy. This strategy can be seen as a guide to various goals and objectives, such as when to enter a trade, when to take profits, or when to cut losses.

Traders can also incorporate certain tools, such as the VIX (volatility index), into their trading strategy, allowing them to gain insights into market sentiment and potential volatility. This could ultimately assist them in making more informed decisions.

This is just a short breakdown, as there are many more factors to consider when constructing a trading and risk management strategy.

Risk Management Strategies

CFD trading carries inherent risks, but traders can mitigate them using key risk management strategies:

• Stop-loss and take-profit orders: Stop-loss orders automatically close losing trades at a predetermined price to limit potential losses, while take-profit orders lock in gains when a price target is reached. Many traders follow a risk-to-reward ratio of 1:2 or higher to optimise returns.
• Position sizing: It’s essential to manage trade size based on account balance and risk tolerance. To avoid overexposure, a common rule is to risk no more than 1-2% of total capital per trade.
• Leverage Risks: While leverage amplifies profits, it also increases potential losses. Beginners should use lower leverage ratios (e.g., 5:1 or 10:1) and monitor margin levels to avoid margin calls.
• Regulation and protection: Trading with a regulated broker such as Trade Nation ensures compliance with industry standards, including negative balance protection and provides a safer trading environment.

How to trade CFDs with Trade Nation?

If you feel ready to dive into the world of CFD trading, we offer a variety of financial instruments for traders who want to start CFD trading, such as forex, indices, commodities, shares, and more. 

Opening an account with us only takes a few minutes.

• To get started, you could sign up by creating an account. This is where you deposit funds and keep track of all potential profits and losses.
• You will also have all the necessary tools available to start CFD trading.
• Submit all the necessary documents for your account to be approved.
• After the account is open and all documents submitted, you can decide which financial instruments and assets you want to trade. You could research which markets will fit your trading strategy and risk management plan beforehand.
• Once everything is in place, you could start trading forex through Trade Nation, which is regulated and authorised by the UK Financial Conduct Authority (FCA), Australia’s Australian Securities and Investments Commission (ASIC), the Bahamas Securities Commission of the Bahamas (SCB), the Seychelles Financial Services Authority (FSA), and South Africa’s Financial Sector Conduct Authority (FSCA).

*As a side note, CFD trading should be done with caution while having a solid risk management plan to limit any potential losses that could occur on their trading accounts.