What is CFD Trading? Contracts for Difference Explained

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Updated: 26 August 2020

CFD trading is a popular form of trading amongst retail traders with many new accounts that are opened being CFD ones.

There are a lot of benefits to trading CFDs, but it also comes with risks.

In this article, we will take you through everything you need to know about CFD trading. Scroll down to find out:

  • What a Contract For Difference is
  • What CFD trading is
  • How CFD trading works
  • What a CFD spread is
  • The benefits of CFD trading
  • The risks of CFD trading
  • And how to trade CFDs

What is a CFD?

A CFD, or Contract For Difference, is a form of trading that allows a trader to trade the price of a financial instrument, without owning the underlying asset. It is essentially an agreement between the trader and the CFD broker to exchange the difference in value between the opening price and closing price of the position.

One important point to note is several countries do not allow CFD trading, with the main one being the USA.

What is CFD trading?

How Does CFD Trading Work?

CFDs work by permitting traders to trade the price changes of numerous financial market assets, entering a position based on whether they think the asset will rise or fall in price.

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 value of the CFD also increases and they could then sell the position for a profit.

The difference between the buy price and sell price of the CFD is the profit (or loss) from the trade. This is then settled in the trader’s account with the broker.

Conversely, if the trader thinks the underlying asset will fall, a sell position can be entered and then a purchase is made to offset the trade. Once more, the difference between the prices is the gain (or loss), which is cash-settled via the traders account with the broker.

Margin and Leverage

Margin

Margin is a portion of your account balance that the broker sets aside to allow you, the trader, to trade. For example, if you wish to trade a EURUSD position, to be able to take that trade, the broker will set aside a certain amount of money in your account that cannot be used until the EURUSD position is closed.

Leverage

Leverage, which I am sure many of you have heard of, is the ability to use the broker’s funds to increase the size of your trading position. It allows you to trade positions sizes larger than what would be available in your trading account.

Using leverage can help to increase account sizes fast, but it can also result in extremely large losses, so you have to be careful when using leverage. Use it to help increase your profits, but make sure you are not over-leveraged.

benefits of trading CFDs

Costs of CFD Trading

Spread

A CFD spread is the difference between the price you can buy a CFD or sell a CFD. The two prices are sometimes referred to as the bid and ask. The spread can also be referred to as the bid-ask spread.

For example, if you are trading the EURUSD and the current price is 1.1210, and there is a two pip spread. The price you will be able to buy the EURUSD CFD at is 1.1211, and the price you will be able to sell it at is 1.1209.

Holding Costs

Each trading day closes with the end of the New York trading session, (10 pm London time). If you still have positions open in your account, CFD brokers charge what is known as a holding fee. The direction of your trades, at the end of the trading day, will determine whether these costs are positive or negative based on set calculations for each broker.

These calculations include variables such as the number of units held, the opening trade price, the holding rate, and the broker’s currency conversion rate. The resulting amount will then either be credited to your account or debited from it.

CFD trading, how does it work

Benefits of Contracts for Difference

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 asset 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:

  • You can both buy (go long) and sell (go short) multiple asset classes – As it says, you can buy and sell assets as you are merely speculating on its price movements.
  • You can trade with greater leverage – Leverage was mentioned earlier. When trading CFDs brokers will allow you to open positions using greater leverage.
  • They can be used as a hedging tool for longer-term, physical investments – Let’s say you buy Apple stock outright (not via CFD trading), and the price goes against you. You can then short Apple via your CFD trading account and hedge your position.
  • Low trading costs – This is self-explanatory but there are only holding costs and spreads associated with CFD trading and you won’t need to pay commission.
  • Trades do not expire

Risks of CFD Trading

While CFD trading carries many potential rewards, some risks come along with that. It is essential to be aware of the risks associated with CFD trading before you start. For example, trading with increased leverage can lead to increased losses.

Some of those risks are:

  • Losses can be magnified – Especially if you are trading on leverage, losses can be large. You may also notice that there are always disclaimers on broker websites notifying you that losses can exceed deposits. Meaning, you can lose more than you put in. Risk management is key.
  • Rapid changes in price could wipe out your account – Let’s take you back to 2015, you have a long EURCHF position, the swiss is pegged to the euro and there is an unofficial level that the EURCHF always bounces up from due to the SNB defending that level so the CHF doesn’t get too strong.

Risks of CFD Trading

Then the Swiss National Bank unpegs the Swiss franc from the euro and the price collapses from 1.20 down to 0.96, a 41% drop. Stop-losses are there to protect you, but if there is an enormous move that happens so fast your SL may not trigger quick enough and will get you out a lot lower than you expected (slippage), leading to an enormous loss in the EURCHF case. A case like the EURCHF one is extremely rare, but it is important to note that big swings in price can lead to larger losses than expected.

  • Overnight holding costs – These are small, but if you have a small account they will eat away at it over a period of time. It is important to factor in these costs to your trading.

CFD Trading Tips

Now you have got to grips with CFD trading, let’s give you some tips to help you on your way.

  1. Risk management  – Probably the most important tip of all. It is vital that you manage your risk. Poor risk management will lead to large losses and your account will be wiped out quickly. It is advised that you only risk 1-2% of your account per trade.
  2. Backtest strategies – Would you open up a business without a business plan? Probably not, and trading is exactly the same, you have to have a good strategy. The only way you will know it is good is by backtesting it over a sustained period of time.
  3. Calculate fees into costs – CFD trading fees were mentioned earlier in this article, but it is important to calculate them into your trading costs beforehand. If you are backtesting a strategy, take into consideration how the spread will impact where your entry and exit point is. Also consider if you will be holding trades overnight, and how much that could charge you in holding costs.
  4. Make sure you have a reputable broker – Finally, brokers. Make sure the broker you open a CFD trading account with is regulated in the region you are in and has a generally positive reputation amongst current customers. Do your due diligence, don’t get caught out by scam brokers.

How to Trade CFDs

Trading CFDs is a straightforward process, and as mentioned at the beginning of this page, it is prevalent amongst traders.

To trade CFDs, you will need to:

  1. Compare CFD brokers
  2. Open a CFD trading account with a broker
  3. Fund the account
  4. Open up the brokers trading platform
  5. Choose the market you want to trade
  6. Decide whether to buy or sell
  7. Add in your trade size, add a stop-loss and take-profit
  8. Finally, open the position

How to Trade CFDs

The Bottom Line

Contracts for Difference or CFDs are a popular way of trading and offer traders and investors easy entry to a wide range of assets and the ability to trade with high leverage and low margin requirements.

However, it is always important to remember the risks associated with CFD trading so that you limit the potential for losses on your account.

Remember, the majority of investor accounts lose money so it is important to do your homework.

There are restrictions in place in Europe to protect traders, but you must manage risk.

If you are looking for a reliable CFD broker to trade with, then check out our CFD broker reviews.

FAQs

A lot size is the size or quantity of a financial instrument that you wish to buy. In CFD trading it will be the size of your trade.  For example, one lot in gold is equivalent to 100 ounces. In CFD trading, you can adjust the lot size to increase or decrease the value per point of movement.

You are able to trade a variety of different types of CFDs from spot, futures and options markets.

There are many different CFD markets that you can trade on from stocks, forex, cryptocurrencies, commodities, and bonds. As long as the broker you are with offers those options you will be able to trade them. Compare the best CFD brokers.

No, CFDs don’t have any expiration date. You can hold positions for as long as you want. However, if held too long holding costs will start to accumulate and could make a dent into any potential profits you make.

CFD trading profits are not liable for stamp duty, however, they are considered a capital gains tax asset and are liable for capital gains tax. The tax benefits are not the same as when you trade on a spread-betting account.