What is CFD trading & how does it work?

Key Takeaways

• A contract for difference (CFD) is an agreement to exchange the difference in the value of a financial instrument between the opening and closing dates of the contract.
• A CFD trader never truly owns the underlying asset but rather earns compensation or realises a loss,  depending on the asset's price fluctuation.
• CFDs provide access to the underlying asset at a cheaper cost than buying the asset directly, as well as ease of execution and the opportunity to go long or short.
• CFDs provide you with the opportunity to trade on margin.

Contracts for difference (CFDs)

Trading CFDs (contracts for difference) is a type of market speculation that does not require buying or selling of any underlying assets. Traders get into a contract with the broker when they agree to trade CFDs. If going long, that is speculating on a rise in an asset’s price, the trader, also known as the "buyer," and the broker, sometimes known as the "seller," enter into a contract in which they bet on the price of an asset under market circumstances. While the trader speculates on financial instruments, it is important to understand the essential difference between CFDs and ordinary trading.

CFDs enable traders to benefit from price fluctuations without owning the underlying asset. By not owning the underlying asset, CFD traders may avoid some disadvantages and expenses associated with conventional trading.

What is CFD trading?

CFDs are derivatives since they enable you to trade financial markets such as stocks, currencies, indices, and commodities without holding the underlying assets.

When you trade a CFD, you agree to swap the difference in the price of an asset between when the contract is opened and when it is closed. One of the most significant benefits of CFD trading is the ability to profit on price changes in either direction, with the amount of profit or loss determined by how correct your prediction is.

How does CFD trading work?

In CFD trading, brokers build a popular derivative, take an underlying market, and create a new trading instrument. The same rules do not bind this new trading instrument as a spot trading market, which only permits traders to buy or sell assets they currently own.

Now that you know what contracts for difference are, it's time to look at how they work. Spreads, transaction sizes, durations, and profit/loss are four of the most significant CFD trading concepts.

CFD trading examples

Contracts for difference enable you to bet on the price fluctuations of assets in either direction. This means you can speculate on a market rising in price (by going long) and also on it falling (by going short).

When you open a CFD position, you choose the quantity of contracts to trade, and your profit grows with each point the market moves in your favour. Likewise, your losses will increase for as long as the market moves against you.

Going long on CFDs

You believe Tesla shares will rise in value and want to create a long CFD position to capitalise on this potential opportunity.

You buy 10 CFDs on Tesla shares at $160 a share for a total trade value of $1,600. If each CFD is equal to a $1 move in the share price of Tesla, then if the share price rises to $170 per share, you will have made a $100 profit ($10 x 10 CFDs).

Going short on CFDs

Suppose you believe the price of Tesla shares will fall and wish to benefit from this movement. You may benefit from a declining market by opening a short CFD position (also known as short-selling).

Assume you decide to sell 10 CFDs on Tesla for $180 per share (and assuming once again that each CFD is equal to a $1 move in the share price of Tesla), and the price subsequently falls to $170 per share. You will have earned a $100 profit ($10 x 10 CFDs).

What is a CFD account?

A CFD account gives you access to over a thousand financial instruments. These are traded on margin which means that you are employing leverage, and that you have the opportunity to sell short and attempt to profit from a falling market just as easily as going long to speculate on a market rising. With us, you trade CFDs on our MT4 platform.

Before we can open a CFD account for you, we need to assess your knowledge and understanding of our products and services. We will also require proof of identity and address. Please contact our Customer Success team for further details. In the meantime, feel free to practice CFD trading on our demo account.

CFD trading vs spread trading

With CFDs, the currency you trade in depends on the specific market. If you normally use GBP, but the trade you want to take is valued in USD, your profit or loss will be in USD too. You can see this in the example above. Tesla is valued and traded in US dollars. So, you'll need to consider the impact this could have on how much you could win or lose. Currency exchanges will be involved, too, adding to your overall dealing costs.

Spread trading allows you to deal in your preferred currency, so you always know where you stand. You can also choose the amount per point yourself, given certain minimum sizes. This gives you considerably more control over how you trade. It also makes it much easier to calculate your profits or losses.

With CFD trading, the amount per point is decided by the provider.

For example, for the US 500 index, the provider could say 1 CFD is worth $10 per pip, with a pip being worth 1 full US 500 point. But another provider may decide that  0.1 of a point is a pip.

Advantages of CFDs

Popular markets

One of the key benefits of CFD trading is the ability to speculate on popular global markets without owning the underlying asset. 

Traders can have access to derivatives on markets such as:

• Forex - currency crosses i.e. EURUSD
• Indices - a bundle of stocks i.e. Germany 40 (based on the DAX 40)
• Stocks - equity products i.e. Tesla
• Commodities - metals and energy products i.e. Gold and crude oil.

As a result, CFDs are financial derivatives which can be the basis for an effective strategy for diversifying your exposure. 

Ability to go short

Opening a short position with a CFD is effectively the inverse of going long. CFDs are also popular for hedging as a result of this. Hedging is a trading strategy and a key attraction for those that do so.

Leverage

Leverage is the amount we lend you against your deposited amount. It can be denoted in a ratio such as 1:10, which means we provide you with 10 times more capital to trade than your own deposit.

Margin

You receive a margin call when your balance falls below your margin requirement. .  If you do not deposit enough money to clear the margin, the position will be closed automatically.

Spreads

The spread is the difference between the selling and the buying price. This is the major cost when trading, so the narrower the spread, the lower the cost of trading. This cost can impact more than the overall profit. For instance, it may influence the ability to execute strategic entries and exits which depend on reliably low spreads.

Final thoughts

As you can see, CFD trading allows you to trade a broad selection of markets for a little initial investment. Leverage allows you to magnify your gains and losses, and the freedom to go long or short allows you to benefit from both rising and declining markets.

However, as with any speculation, there is a potential for losing money, as well as winning. To increase your chances of success as a trader, ensure you have a thorough understanding of the markets, a tried and tested trading strategy, and solid risk management.