What is CFD trading — how does it work?

Contract for differences (CFDs) is a derivative product much the same as spread betting, where a trader speculates on the price movement of various financial instruments. These financial instruments include stocks, bonds, forex, commodities, indices, etc.

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.

For example, traders trading CFDs in the UK don’t have to pay stamp duty tax because they don’t take ownership of the underlying asset.

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

Instead, a CFD trade is closed once the trader opens a trade in the opposite direction to the one they already have 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.

With CFD trading, a contract of agreement is 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 will buy or sell several units (also called contracts) from their chosen financial instrument, which is linked to an underlying asset. A trader won’t take ownership of the underlying asset through CFD trading, unlike traditional trading, where they would take 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 open 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.

As CFD trading is a derivative product, trading is also done through the use of leverage, where 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.

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.

Now that we’ve gone over some of the necessary details regarding what CFDs are 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 will be 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, with each CFD being 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 will multiply the amount 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, which gives them a profit of $100. To calculate the profits for a shorting position is the same 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.

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.

A CFD account allows you to trade over various financial instruments by speculating on the price movements of various financial assets to potentially make a profit.

This is done through trading on margin using leverage, which means a trader only needs to put down a small amount of capital, which refers to the margin.

A trader might want to ensure they always have sufficient funds to cover any potential losses. This amount can also be referred to as maintenance margin; this amount can fluctuate depending on the price of the asset they might be trading.

If a trader sustains consecutive losses and the maintenance margin can’t cover these losses anymore, a trader might get a margin call notification. This notification indicates additional funds might need to be added to the account; otherwise, the broker could close all open trades automatically.

Before a broker allows a trader to use margin, they might want to gather more information, like 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 will require new traders to answer some questions to test the trader’s knowledge to ensure they understand the risks involved with margin trading. It might be best first to learn how trading with leverage and margin works.

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 will state they are commission-free, this will usually be compensated by a wider spread. 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 their trades’ value depending on the position they have open and the direction of the market.

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 regarding CFD trading vs 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 for every point the market moves in their predicted direction.

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

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

Market availability

CFDs are derivative products, which means the prices are derived from financial instruments in the underlying market. This gives traders the ability 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.

With that said, traders could use CFD trading to diversify their portfolios to 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 with the ability to open short (sell) positions because even though possible, it’s difficult to 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. This could enable them to offset any losses they might sustain from Google's price decline.

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 like any other form of trading, risks are involved. 

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.

And because CFD trading is done through leverage, there is a possibility to lose more than the initial margin amount required to open a trade. The reason behind this is that with leverage, profits and losses are calculated based on the total value size of the trade and 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 disadvantage for traders.

When a trader's account sustains consecutive losses, a margin call notification might be sent out, which states that additional funds must be added to their account. The broker could automatically close all their open trades if this is not corrected.

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.

There is also a case of some brokers who don’t charge commissions on opening and closing trades but 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.

As previously mentioned, CFD trading, as with any form of trading, presents some risks that might need to be considered. For this reason, risk management 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, the first factor they might want to consider is deciding which markets they wish to trade. 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 guidelines with various goals and objectives in place, such as when to enter a trade, when to take profits, or when to cut losses. 

There is more that goes into a trading plan; this is just a short breakdown.

A trading strategy goes hand-in-hand with a risk management strategy.

If a trader doesn’t have time to monitor the charts all day, they could also implement a stop-loss into their risk management strategy. A stop-loss is a fixed level set up by the trader, which could protect them when the market goes against them.

When the market reaches this level, the trade will close automatically, limiting any more significant losses that could’ve occurred. However, a stop-loss could still be implemented even if a trader has time to monitor the charts.

Stop-loss orders aren’t always perfect, especially in volatile markets when there is a sudden shift in price. When this happens, the stop-loss order could be triggered at a less desirable price.

Another order form that could be placed is a take-profit order, which is just the opposite of a stop-loss. It’s a fixed level set up by the trader for when the market moves in their favour. When the take profit level is reached, the trade will close automatically, securing their profits.

A take profit forms part of a risk management plan in order to protect a trader's potential profits when the market might reverse and move against their prediction.

A last point that might be essential to a trader's risk management plan is trading only with capital they can afford to lose.

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, regulated and authorised by the UK Financial Conduct Authority (FCA), Australia’s Australian Securities and Investments Commission (ASIC), Bahamas Securities Commission of the Bahamas (SCB), 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.