CFDs are an incredibly popular and user-friendly way to trade the financial markets. The use of an abbreviation might at first glance make you think that they’re complicated. In fact, the opposite is true.
Becoming a successful trader involves learning and developing a range of new skills. A good first step is to get a better understanding of what CFDs actually are.
In this guide, you’ll discover:
CFD is an abbreviation of ‘contract for difference’. Every trade put on by an individual is an agreement between the individual and the broker they are using. If you buy an asset – for example, gold or bitcoin – and the price goes up, the ‘difference’ between your entry price and exit price will represent your profit. If the price goes against you, the ‘difference’ between the entry and exit price will determine your loss.
Millions of people trade CFDs because they come with a lot of neat features. Here are some of them:
The price of the CFD you are trading will move up and down according to the price of the asset it represents. If you hold a long position in oil CFDs and the price of crude falls by 5% on the exchange, then the value of your holding will also fall by 5%. There are other risks that are also worth factoring in:
There are many possible ways to lose money when trading CFDs. Market risk is unavoidable, leverage multiplies any losses, and you can just get the basics of booking a trade wrong.
One very significant risk that stands out from the list above is counterparty risk. Putting on a position in a CFD trading account means that you are setting up a contract between yourself and your broker, rather than a direct investment in the markets. This explains why a CFD is a derivative product. The price of your position is derived from prices in the underlying market.
All CFD providers will insist that you place funds with them before allowing you to live trade the markets using CFD products. If your trading is unsuccessful, they will automatically debit your investment account.
However, the broker doesn’t place money upfront in your account to ensure that you get paid out if your trade is successful. This means that most of the protection of individual traders is largely down to the approach of regulatory authorities. You should look out for the following:
Take a leaf out of the book of the big investors. Pension funds and family offices have designated teams whose job it is to check and then monitor third parties. You should also be proactive in doing what you can to ensure that your money will be safe.
Due diligence (1) – Only use regulated brokers.
CFD brokers that operate under licence from any of the below Tier-1 authorities have to comply with a range of rules and regulations that are designed to protect their clients.
Due diligence (2) – It’s also worth crowdsourcing the thoughts of others in the trading community. Regulators offer some protection, but if you’re wiring funds to a third party, then a Google search about whether it is trustworthy is always a good option.
Terms to know
Before doing into detail, it’s worth revisiting a high-level overview of how CFDs work.
CFDs involve a broker monitoring the price of an asset in a real-life market, and providing you with the opportunity to sell or buy a position in it. If you buy and the price goes up, then you make a profit. If you sell and the price goes up, then you make a loss, and vice versa.
The platforms provided by top-tier brokers are user-friendly and come packed full of tools and learning materials to help you develop your trading skills. The monitors have live-market feeds so that the price of your position matches the price of the underlying.
The data feeds are all automated, and you can watch the world’s financial markets moving in real time. You’ll feel like you are trading the markets – because you are. The CFD you trade is just an instrument that provides an easy and convenient way to do so.
The risks associated with leverage are possibly best described by the process involving you buying (or selling) more than you can ‘afford’.
A non-leveraged trade involves exchanging an amount of cash for the same amount of an asset – for example, using $500 to buy $500 worth of Apple Inc. stock.
Using leverage of 1:5 involves buying $2,500 of Apple Inc. stock but only using your $500 as margin – a deposit on the position. If the profits move rapidly due to leverage being part of the trade, then the broker still has your $500 as collateral.
In the leveraged scenario, any price move will have a x5 impact on your P&L. If the price goes down 10%, then in the first example, you’ll lose $50, and in the second, you’ll lose $250.
In cash terms, the leveraged trade will see the price of the underlying asset move by 10%, but your capital will suffer a 50% hit. Your balance will fall from $500 to $250.
As with most things, the mechanics of a CFD trade are best understood by going through an example.
We’ll put on a CFD trade using the Pepperstone demo account. Pepperstone will provide us with an initial balance of €10,000 in virtual funds. We’ll practice trading with that until we get things working correctly.
Logging onto the platform will take you through to the trading dashboard. Our analysis points to the tech stock bull run continuing, so we are looking to buy units of the Nasdaq 100 index (NAS 100).
Clicking on the market for NAS 100 takes us to a dashboard where we can see the price chart, trading volumes, and the ‘buy’ and ‘sell’ buttons on the trade execution sidebar.
Deciding to buy 10 lots, we enter that number into the required data field. As soon as ‘buy’ is clicked, we have opened a trade, and we can see the P&L on the position start to move.
The P&L on our CFD position in NAS 100 will be calculated as per the below formula:
= Opening price +/- Live price x Size of your holding
= 12067.2 +/- Live price x 10 lots
A few moments after opening the long position in NAS 100, the price has fallen to 12055.4. Our position shows a negative P&L of -$110.80. This is calculated as follows: 12067.2 – 12055.4 x 10.
Your CFD position will continue to post real-time unrealised P&L.
Approximately one hour after our trade was first put on, the market has moved in our favour. The price that we can sell our position at is now 12147.6, which converts to an unrealised P&L balance of more than €600. We take the offered closing price and exit the trade.
It’s never a bad idea to lock in some profits. A decision is made to sell our 10 lots of NAS 100. This secures a realised profit €613.
After closing out our trade, our cash balance increases by €613 to €10,613, and our market exposure falls to zero. We now have no open positions.
Stop orders are automated instructions to close out your position. They mean that you can manage the risk and return on your trades without having to watch a screen the whole time.
A stop-loss order will sell a position if it makes a certain loss. A take-profit order will close out a position and lock in the profits. You decide whether you want to use these and what price levels they are set at.
When you have found the right broker, it can be tempting to jump straight in. However, avoid the temptation and start practicing first on a demo account. Even experienced traders use demo accounts if they are testing a new strategy idea. Looking after your cash balance is crucial, and it’s recommended that beginners start trading using virtual funds. They offer a chance to iron out operational errors as well as trading ones.
You’ll notice from the image of the Pepperstone trading platform that at the time of trade, the prices to buy and sell were different – 12067.2 in relation to 12065.3. This is the bid-offer spread and a characteristic of CFD trading.
This spread is how brokers make most of their income, but the good news is that competition between firms means that they don’t get too wide. Even so, it’s always worth checking that the spreads offered by your broker are in line.
CFDs were invented in the 1990s as a means of allowing traders to access the markets more tax efficiently. In the UK, Stamp Duty Reserve Tax (SDRT) is a charge applied to purchases of equities. It’s calculated as 0.5% of the value of your position.
A lot will come down to where you live. However, it’s worth noting that one of the advantages of using CFDs rather than the traditional approach to buying equities is that sometimes the SDRT charge is removed from your P&L.
Now that you have got to grips with the mechanics of CFD trading, it’s time to develop an effective trading strategy. As you might imagine, there are countless approaches to trading the markets. Some of them are:
The key to strategy choice is to find the one that suits you. Different strategies require different skill sets. Some strategies take up more of your time than others. Researching different approaches is worthwhile and best done in a demo account.
CFD trading can be seen to come with certain benefits. Some of these are specific to the way that CFD financial instruments work. There is also a high risk of losing money, which makes choosing a good broker even more important.
Price will be a consideration, but some brokers that offer basement-level fees provide little else. Educational and research materials will be important if you are going to make the most of your trading.
If you’re looking to trade on the move, then choosing a broker with a high-quality mobile app offering will be important.
Brokers that offer trading signals and trade entry and exit points are particularly popular with beginners.
It is possible to find a broker that ticks all the boxes. This list will help you find a regulated broker that provides a top-quality platform, great customer support, useful research and cost-effective pricing.
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You should be very concerned about the risk of losing your money. Recent upgrades in terms of client protection make it possible to avoid losing more than your initial stake. Look for brokers that offer negative balance protection to avoid this risk.
Both approaches trade the same underlying assets. They also feel very similar when booking actual trades. CFD markets are global and therefore benefit from increased trading volumes. The main difference between CFDs and spread betting relates to taxation protocols that may, or may not, apply to you depending on where you live. Choosing one over the other is largely down to personal preference.
The CFD market is global. However, one country that doesn’t allow CFD trading is the US. This is because it is banned by the US Securities and Exchange Commission.
The difference on the bid offer spread is the way that brokers make most of their money. Account management fees such as overnight financing charges also need to be considered, and sometimes slip under the radar.
Yes. Most brokers offer unleveraged trading as the default. This means that traders can only take on leveraged positions after proactively selecting to do so.