CFD (Contracts for Difference) trading explained

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Updated: 10 March 2020

With Contracts for Difference or CFDs, traders (and maybe even longer-term investors) can trade on the changing value of an asset, rather than buying or selling the actual asst outright. The difference between the open and closing trade prices are settled in cash. The physical asset is not actually owned if bought or delivered if sold.

There are several benefits to this.

  • They can be used to both buy (be long) and to sell (be short) of multiple asset classes
  • They can be leveraged
  • They can be used as a hedging tool for longer term, physical investments

It is worth starting out by discussing just how popular CFD trading has become, or Contracts for Difference, to give it its full title. When online trading began to gain popularity, traders wanted new ways to invest in stocks and other assets without having to play the long only game. CFDs allow you to trade based on whether you think stocks or indices (or a variety of other asset classes) are going to go up or down.

What is CFD trading?

Understanding CFD trading, how does it work?

CFDs permit traders to trade in the price changes of numerous financial market assets and CFDs are investments that are derived from these underlying assets. Fundamentally, CFDs are used by traders to speculate if the price of the underlying asset will go up or down. If the CFD buyer predicts correctly and the underlying asset price rises, the CFD also rises and they could then sell the CFD. The difference between the buy price and the sell price of the CFD would be the profit (or loss) from the trade. This is then settled in the trader’s account at the broker in cash. Conversely, if the trader thinks the underlying asset will fall, a sell position can be entered and then a purchase is made to offset trade. Once more, the difference between the prices is the gain (or loss), which is cash settled via their broker account.

[broker_small type='cfd']

What are the benefits of trading CFDs?

One of the man aspects and advantages of trading CFDs is the ability to easily go short or sell any asset class. The trader or inventors is able to benefit from falling markets, something only a few decades ago was difficult for even financial institutions to do. The ability to sell and be short is now easily accessed by retail traders and investors via CFDs.

The other main advantage to trading CFDs, is that a greater exposure to markets can be achieved by leverage. CFDs are usually traded on margin, which means the CFD broker lets traders effectively borrow money in order to increase their leverage or the scope of their position. This is in order to increase profits and gains. But, this is a double edged sword, as investors are then obviously susceptible to bigger losses. CFD brokers usually stipulate traders to keep certain balances in their account in order to tared in CFDs. This trading on margin usually allows for greater leverage than normal, traditional investing or trading. Leverage offered by CFD brokers can vary, with lower margin requirements meaning that less initial capital is required, which can mean higher possible returns, but also higher possible losses for the trader.

Use CFDs to hedge against unexpected movements

The hedging aspect is one used by those who own the underlying asset class, By betting short on the assets they own through CFDs, if the owner of the underlying asset believes that the asset they own ids going to fall in price, they can offset the loss on the physical asset with a profit on the CFD.

benefits of trading CFDs

Be sure to see which brokers can suit you best

There are a range of brokers to look out for and they will all offer different benefits depending on the type of trader they are trying to tempt to use their broker services. This Contracts For Difference (CFD) guide will therefore shine a light on some of the aspects to consider before picking a broker, so you can ensure you choose the one that suits you best.

  • Always look at user review sites
  • Consider technological and automation offerings
  • Have an idea of how many times you want to trade per month
  • Consider what tools would be useful for you

CFD trading, how does it work




In conclusion

Contracts for Difference or CFDs can offer traders and investors easy entry to a wide range of underlying assets. They can be either long or short of the assets, which means being able to benefit from price increases and price falls. Furthermore, the aspect of leverage and trading on margin allows for potentially higher profits than investing in just the underlying asset. However, the trader should remember that with the prospect of greater profits, also comes the risks of greater losses. Finally, the CFD markets allow for the easy hedging by owners of the underlying assets, which may avoid having to regularly buy and sell these physical assets.