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What is CFD trading? | Definition, Risks, Pros & Cons

What is CFD trading?
Diana
Paluteder
3 months ago
13 mins read

A CDF is a contract made in financial derivatives trading between you and the broker to exchange the difference in the price of a financial product. As such, you will not own the share but simply bet on its price movements. The following guide will examine how CFDs differ from trading in stocks, how to successfully trade them, the risks involved, who has access to them, and the critical terminology around this financial tool. 

CFD trading definition 

A CFD (contract for difference) is an agreement between a buyer and a seller that the buyer must pay the difference between the current value of an asset and its value at contract time. A CFD trader will never truly own the underlying asset but profit from its price movement. The value of a CFD contract accounts only for the price change between trade entry and exit, not the underlying security’s intrinsic value. 

CFD trading enables investors to speculate on various financial markets, such as stocks, forex (foreign exchange market), indices, commodities, and cryptocurrencies. Furthermore, it is an advanced trading strategy that experienced traders generally employ and is not allowed in the United States


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Understanding how CFDs work

A CFD investor will never own the underlying security but rather acquire revenue based on the price change of that particular asset. So, for instance, instead of buying actual shares of Netflix (NASDAQ: NFLX), a trader can purely speculate on whether the price of Netflix will go up or down. 

Short and long CFD trading 

A CFD is composed of two trades. The first trade constructs the open position, which is later closed out through a reverse trade with the broker at a different price. An investor can opt to go long and ‘buy’ if they think the asset’s market price will increase or go short and ‘sell’ if they believe the market price will decrease

If the trader believes the asset’s price will increase, their first trade will be a buy or long position, the second trade (which closes the open position) is a sell. Conversely, if the investor thinks the asset’s value will decline, their opening trade will be a sell or short position, the closing trade a buy. The trader’s net profit is the price difference between the opening and closing-out trade (minus any commission or interest).

Going long example

Your expectation is that the value of Apple’s (NASDAQ: AAPL) stock will increase, and you want to open a long CFD position to take advantage of this opportunity. You purchase 100 CFDs on Apple shares at $160 a share, so the total value of the trade will be $16,000. If Apple’s share price shoots to $170, you make $10 a share, a $1,000 profit. 

Going short example

You believe that Apple stock will decrease in value, and you want to profit from this movement. To do this, you can open a short CFD position (known as short-selling) and profit from a tanking market. This time, you have decided to sell 100 CFDs on Apple at $170 per share, which then proceeds to fall to $160 per share. You will have made a profit of $1,000, or $10 per share. 

Recommended video: How to trade CFDs?

IGTV’s Victoria Scholar explains how CFD trading works, from opening an account to closing your position.

Leverage in CFD

CFD trading is a leveraged product, meaning an investor can gain exposure to a significant position without committing the total cost at the outset. For example, say an investor wanted to open a position equivalent to 200 Apple shares. A traditional trade would mean bearing the full cost of the shares upfront. However, you might only have to put up 5% of the price with a CFD.

While leverage enables the investor to spread their capital further, it is vital to remember that the acquired profit or loss will still be calculated on the total size of the investor’s position. Using the example above, that would be the difference in the price of 200 Apple shares from open til close of the share. Meaning both profits and losses can be massively magnified compared to your outlay, and that losses can surpass deposits. As a result, it is essential to pay attention to the leverage ratio and ensure that you are trading within your means.

Margin in CFD

Leveraged trading is at times referred to as ‘trading on margin’ since the margin – the budget required to open and maintain a position – represents only a fraction of its total size.

There are two types of margins within CFD trading. First, to open a position, you need a deposit margin. Additionally, a maintenance margin may be required if your trade is likely to suffer losses that the deposit margin, including any additional funds in your account, won’t cover.  

Should this happen, you may get a margin call from your broker asking you to top up your account. If you don’t add adequate funds, the position may be closed, and any losses incurred will be realized.

To open a position an investor will only need to deposit a small percentage of the full value of the trade. Source: Cmcmarkets.com

Warning: Trading CFDs with leverage and margin trading is extremely risky and not recommended for conservative or risk-averse investors. Investors should only consider trading in CFDs if they have extensive experience in volatile markets, fully understand how CFDs operate and have ample time to manage their investment on an active basis. 

Hedging with CFDs

CFDs can also be used to hedge against any losses in an existing portfolio of physical shares if you believe they may lose some of their value over the short term. By short selling the same shares as CFDs, you can attempt to counterbalance some of the potential loss from your existing portfolio. Using a CFD hedging strategy means that any drop in the value of the particular shares in your portfolio will be offset by a gain in your short CFD trade.

Key concepts behind CFD trading

Let’s now explain the four key concepts of CFD trading: spreads, deal sizes, durations and profit/loss. 

Spread and commission 

CFD prices are quoted in two prices: the buy price (offer) at which you can open a long CFD and the sell (bid) price at which you can open a short CFD. Sell prices will consistently be slightly lower than the current market price, and buy prices will be slightly higher. The difference between the two prices is called the spread.

Usually, the cost of opening a CFD position is covered in the spread: buy and sell prices will be adjusted to reflect the cost of making the trade.

The difference between the buy and sell price refers to the spread. Source: Ig.com

Deal size 

CFDs are traded in standardized contracts (lots). An individual contract’s size depends on the underlying asset being traded, often mimicking how that asset is traded on the market.

For share CFDs, the contract size typically represents one share in the company you are trading. So to open a position that copies purchasing 500 shares of company X, you’d purchase 500 Company X CFD contracts. This is another way CFD trading is more similar to traditional trading than other derivatives, such as options.

Duration

Unlike options, most CFD trades have no fixed expiry. Rather, a position is closed by placing a trade opposite to the one that opened it. A buy position of 500 silver contracts, for instance, would be closed by selling 500 silver contracts.

An overnight funding charge will be charged from your account if you maintain a daily CFD position open past the daily cut-off time. The amount mirrors the cost of the capital your provider has effectively lent you to open a leveraged trade.

Yet this isn’t always the case, with the main exception being a forward contract. A forward contract has an expiry date at an upcoming date and has all overnight funding charges already included in the spread.

Profit and losses

To calculate the profit or losses made from a CFD trade, you multiply the value of each contract (expressed per point of movement) with the deal size of the position (total number of contracts). Next, you multiply that figure by the difference in points between the price when you opened the contract and when you closed it.

For a total calculation of the return or loss from a trade, you’d also subtract any charges or fees (commission, overnight funding charges, guaranteed stop loss) you paid. 

Fees and charges of CFDs 

Spread: When trading CFDs, you must pay the spread, the difference between the buy and sell price. The narrower the spread, the less the price needs to move in your favor before you start to make a profit or a loss if the price moves against you. 

Overnight Funding: An overnight funding amount is either added to or subtracted from your account when holding a position after a specific time (referred to as the “Overnight Funding Time”). 

Currency Conversion Fee: Will typically be charged for trades on instruments denominated in a currency different from the currency of your account.

Guaranteed Stop Order: A unique order type used to help you manage risks by guaranteeing the stop loss level. 

Inactivity Fee: A possible fee should you not log in to your trading account for a specified period of time by your broker.

Countries that allow CFD trading 

Important: CFD trading is banned in the U.S. However, they are allowed in listed, over-the-counter (OTC) markets in many major trading countries, including the United Kingdom, Germany, Switzerland, Singapore, Spain, France, South Africa, Canada, New Zealand, Hong Kong, Sweden, Norway, Italy, Thailand, Belgium, Denmark, and the Netherlands.

CFD regulations by country. Source: Investopedia.com

Benefits of CFDs

CFDs presents various upsides to traditional trading and can be an attractive possibility to realize significant gains with less capital outlay. 

  • Higher leverage – CFDs provide higher leverage than traditional trading. Lower margin conditions mean less capital input for the trader and beefier possible returns. Nevertheless, increased leverage can also magnify a investors’ losses;
  • Global market access from one platform – Many CFD brokers offer products in all the world’s major markets, allowing around-the-clock access. As a result, investors can trade CFDs on a wide range of worldwide markets;
  • No shorting rules or borrowing stock – Certain markets have regulations that prohibit shorting and mandate the trader to borrow the financial tool before selling it short, on top of having different margin requirements for short and long positions. However, CFD instruments can be shorted at any time without borrowing costs since the trader doesn’t own the underlying asset;
  • No day trading requirements – Certain markets demand minimum amounts of capital to day trade or limit the number of day trades allowed to be made within certain accounts. These restrictions do not apply to the CFD market, and as such all account holders can day trade if they wish to do so;
  • A mixture of trading opportunities – Brokers currently offer shares, index, treasury, forex, cryptocurrency, and commodity CFDs. This enables speculators interested in diverse range of financial instruments to trade CFDs as an alternative to exchanges.

Drawbacks of CFDs

While CFDs offer a lucrative alternative to traditional trading practices, they don’t come without potential pitfalls. 

  • Investors pay the spread – Paying the spread on entries and exits takes away the possibility to profit from small moves. The spread will also reduce winning trades by a small amount compared to the underlying security and increase losses by a small amount. So, though standard markets expose the trader to various fees, regulations, commissions, and higher capital requirements, CFDs cut investors’ profits via spread costs;
  • Weak industry regulation – The CFD industry is not highly regulated. A CFD broker’s credibility is not based on government standing or liquidity but rather reputation, longevity, and financial position. For that reason, it is paramount to investigate a broker’s background before opening an account with them;
  • Leverage risks CFD trading is fast-paced and demands close monitoring. You need to maintain liquidity risks and margins, and if you cannot cover reductions in values, your provider may close your position. You’ll have to cover the loss no matter what subsequently happens to the underlying asset.

In conclusion 

To sum up, a contract for differences is a highly flexible tool that allows traders all the benefits of owning a security without actually owning it. What’s more, CFDs grant investors global access to financial instruments, shares, commodities, and indices they might not otherwise have very liquid access to. 

CFDs provide higher leverage than traditional trading, which can significantly amplify your gains. However, it will also magnify losses when they occur, with the possibility of losing more money than you have available to invest. 

Compared to other traditional forms of trading, trading CFDs is a risky strategy and should be approached with caution by beginner investors. That is precisely why the most successful CFD traders are typically seasoned investors with a wealth of experience and tactical acumen. 

CFD trading FAQs

What is the main difference between stock trading and trading CFDs?

The main difference between trading contracts for difference and share trading is that when you trade a CFD, you speculate on a market’s price without taking ownership of the underlying asset. In contrast to share trading, where you are actually gaining ownership over the underlying stock.

How do CFDs work?

CFDs allow traders to speculate on the future market movements of an underlying asset without actually owning it. A CFD involves two trades between the client and the broker. The first trade creates the open position, which is later closed out through a reverse trade. If the first trade is a buy (long position), the second trade (which closes the open position) is a sell. If the opening trade was a sell (short position), the closing trade is a buy. The trader’s net profit is the price difference between the opening trade and the closing-out trade.

What are some of the advantages of CFDs?

CFDs are an extremely flexible tool, providing traders with lower margin requirements, uncomplicated access to global markets, no shorting or day trading rules on top of little or no fees. Finally, CFDs provide you with the possibility to trade virtually anything very quickly and accessibly in your currency. 

What risks are involved trading CFDs?

CFDs allow you to have high leverage, which can be both an enormous benefit or the most significant risk factor. Leverage, without a doubt, is a double-edged sword when it comes to CFDs since you are trading with borrowed money, allowing you to gamble with cash you don’t, in reality, have. 

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Diana Paluteder
Author

Diana is an economics enthusiast with a passion for politics and investing. Having previously worked as a financial translator, she provides in-depth articles and guides on the world of finance and commerce.

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