What is CFD trading

& how does it work?

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DEFINITION

Contract for difference trading

A contract for difference (aka a CFD) trade is essentially where you trade on whether the price of a market will increase or decrease in the short-term. If you predict correctly, your profits are determined by the price difference between your opening and closing trade. This price movement also determines how much money you lose if you turn out to be wrong.

CFD trading is popular as you don’t actually need to own the thing you’re trading on. For example, you could trade on the price movement of Apple stocks without having to buy them. There’s less financial commitment in this sense, which obviously has its appeal. This also means you have the option to trade and profit from markets that are falling in price as well as those that are rising.

However, the way CFD trading works means it’s all too easy to overtrade, and losses can be hugely magnified compared to the amount of money you need to open the trade. What’s more, you have no say in the currency you’re trading in, which may result in additional costs and complications.

Is CFD trading right for you?

We’re guessing you’re here because you’ve heard about CFD trading and think it’s the right way to start your life as a trader. Before you dive in, we want to make sure you know what’s what. CFD trading certainly isn’t straightforward and there’s a lot of confusing terminology involved too. This means it usually isn’t the best way for traders to kick off their journey.

If you really want a flying start in trading, we think you’d be a perfect fit for Trade Nation. We’re all about helping beginners get to grips with trading and breaking down complex jargon so it’s easy to understand. Let us explain everything you need to know about CFD trading and you can then make that decision for yourself.

Things you might hear CFD traders say

“Going long” & “going short”

Going long means you are buying contracts as you believe prices will rise. Going short is the opposite —selling them predicting prices will fall.

How does CFD trading work?

Every contract has a sell price and buy price, which are respectively slightly lower and higher than the current market price. The difference between the buy and sell prices is called the spread and this reflects how much it will cost you to make the CFD trade.

If you reckon prices on a market are going to rise, you buy a number of CFD contracts (also called units). On the flip side, you sell these contracts if you think prices will fall. It’s possible to trade CFDs on lots of financial markets like forex, commodities, stock indices and shares.

There are no fixed expiry dates on CFD trades so in order to close your position, you have to place a trade in the other direction. For example, if you bought 500 contracts, you would sell them. It’s also worth bearing in mind that you will have to pay interest every time you keep your trade open overnight. These fees can add up, which is why CFD trading isn’t suitable for long term positions.

EXAMPLE

Let’s look at a CFD trade on the US 500 index

In this example, the CFD provider has stated that 1 CFD is worth $1 per pip, and a pip is equivalent to 1 full US 500 point. If the US 500 rises 1 point, you would make $1 profit.

The sell and buy prices on the US 500 are 3.151.0 – 3.151.5. You believe prices are going to rise so you buy (or go long) 2 CFDs at 3.151.5.

The total value of your trade is calculated by multiplying the price you have traded at, by the number of $ per pip you have bought:

3151.2 x $2 = $6,302.40

There is a 5% margin charge for a trade on this market, 5% of $6,302.40 is $315.12 so this is all you need in your account to make the trade.

How a trade might play out

A WINNING CFD TRADE

You're correct and prices do increase. You close your position when the US 500 quote is 3,223.4 - 3,223.9, selling 2 CFDs for 3,223.4.

Calculate the difference between the opening and closing trades, then multiple by the number of CFDs to see your profit.

3,223.4 - 3,151.5 = 71.9 points

71.9 x 2 CFDs = $143.80

A LOSING CFD TRADE

Unfortunately the market has moved against you and you have to sell 2 CFDs to close your position.

Now the US 500 quote is 3,102.2 - 3,102.9 and your loss is calculated like this:

49.3 x 2 CFDs = $98.60

3,151.5 - 3,102.2 = 49.3 points

How a trade might play out

A WINNING CFD TRADE

A LOSING CFD TRADE

You're correct and prices do increase. You close your position when the US 500 quote is 3,223.4 - 3,223.9, selling 2 CFDs for 3,223.4.

Calculate the difference between the opening and closing trades, then multiple by the number of CFDs to see your profit.

Unfortunately the market has moved against you and you have to sell 2 CFDs to close your position.

Now the US 500 quote is 3,102.2 - 3,102.9 and your loss is calculated like this:

3,223.4 - 3,151.5 = 71.9 points

71.9 x 2 CFDs = $143.80

49.3 x 2 CFDs = $98.60

3,151.5 - 3,102.2 = 49.3 points

This sounds a bit like spread trading - is it?

We’ve already mentioned that CFD trading involves a spread, making this quite similar to spread trading , which is what we offer here at Trade Nation. Both types allow you to speculate on financial markets, but spread trading is arguably the most straightforward way to do this.

CFD vs spread trading in brief

With CFDs, the currency you trade in depends on the specific market. If you normally use GBP but the trade you want to make is in USD, you’ll need to consider how this influences how much you could win or lose. Currency exchanges will be involved, adding to your overall costs. Spread trading, on the other hand, allows you to use your preferred currency, so you always know where you stand.

Spread trading also allows you to choose the amount per point yourself, giving you total control over how much you’re trading and making the figures much easier to understand. However with CFD trading, the amount per point is decided by the provider instead.

For example, the provider could say 1 CFD is worth $10 per pip, with a pip being worth 1 full US 500 point, but they may also say 0.1 of a point is a pip. This can lead to further confusion when you’re trying to calculate potential profits and losses.

CFD TRADING IS TRICKY, RIGHT?

We haven’t even mentioned all the hidden costs...

Still feeling a little confused? Don’t worry. Like we said, CFD trading can be very complicated, especially for new traders. It can also be a lot more expensive than you probably think. We’ve already mentioned that you may need to convert any profits you make into the currency of your choice so you can actually withdraw it. Guess what? Your provider will charge you a hefty premium for that. You’re paying for your own money. And that’s on top of the fees you’ve paid to make the trade in the first place.

Another thing to bear in mind is that the spread on CFD trades can move overnight. The spread determines how much it will cost you to make the trade and this can change daily, so you’ll never know for sure what your transaction rates are. These could add up to be far more expensive than you expected. On top of this, you often have to pay a commission fee on CFDs as well.

It doesn’t need to be this way though — there’s a much better way to trade.

What if we said you could avoid secret expenses and know all the fees up front?

Here at Trade Nation, we’re always completely transparent about any charges so you’ll never be taken by surprise. And as we offer spread trading, you can speculate on the markets in a currency of your choice. Plus, all our spreads are fixed, which means your transaction rates will never unexpectedly change.

If, in spite of all this, CFD trading is still an avenue you want to explore then we wish you the best of luck. But if you want a simple way to trade free from unfair hidden charges, why not join the Trade Nation community? We’re all about making trading honest and easy to understand, and will be here to help every step of the way!

Set up a practice account, it’s free!

Financial spread trading comes with a high risk of losing money rapidly due to leverage. You should consider whether you understand how spread trading works and whether you can afford to take the high risk of losing your money.