How to Trade CFDs: An Introduction

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Updated: 04 March 2020

CFDs have steamrolled into popular investing and success stories abound yet judging by the number of traders who have made hasty retreat from CFDs, there is a lack of education in this field. Most traders think they know what it takes, but few actually manage to be successful over a sustained period. However, CFD trading continues to have big appeal thanks to small margin requirements, direct global market access, a lack of shorting or day trading rules, and the low associated fees. Despite this, the leveraged nature of CFDs means losses can be swift and severe.

We will examine:
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  • How to choose a good CFD broker
  • The primary rules you must stick to if you are to succeed
  • The secondary rules that will take you from average to good
  • The kinds of benefits that can inform your trading strategy

An Overview of CFD Trading

CFD stands for contract for difference, a differential in price when buying and selling. In CFDs, you essentially ‘bet’ or speculate on instruments either falling or rising. These instruments can be currencies, shares, indices, commodities, treasuries and more. CFDs are a tax-favourable investment form in the UK, as you don’t have to pay stamp duty on them. You can trade in CFDs using spread betting to gain from the price of an asset you’ve speculated on going up or down.

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In CFD trading, you sell if you think prices will go down or purchase if you think they will rise. You can buy or sell a number of ‘units’ of the asset at a time. For every point the price of the instrument moves the way you said it would, you gain multiples of the number of CFD units. For every point the price goes the other way though, you’ll make a loss – also in multiples. One of the risks that you must grasp at the beginning of your how to trade CFD knowledge, is that your loss can be bigger than your initial deposit.

You can also trade on margin. Margin trading means putting down only a tiny deposit as a fraction of the total value of the trade in order to begin. This allows you to make huge profits as you can win a lot having put down only a small amount. However, you can also lose a huge amount as losses.

How to Choose a Good CFD Broker

When you start out in contracts for difference, it is different to the usual investment offerings such as stocks and ETFs that you should have mastered first. You’re bound to look for a brokerage offering the best selection of assets, the most accessibility, and the lowest fees. So, what should you look for in a CFD broker?

  • Reasonable fees. Some brokers charge 10 or 15 times higher than others. This is sure to eat into your profits.
  • Withdrawal and funding fees. These can be up to 5 times higher than average at some brokers.
  • Product coverage. Will you get an extensive range of assets and can you trade in many countries? How many countries does it operate in locally and not just have a presence in? This impacts how protected you’ll be legislatively and how directly accessible your broker is.
  • The ease of use and functionality of the web trading platform. If the platform is too complicated, can you come to grips with it? If not, it will affect how quickly and efficiently you can execute trades. How much investor education is provided? Can you read the stock charts they provide?
  • Accessibility to markets. When it comes down to it, can you get access to the assets you want?

Consult a broker comparison written by professional, experienced traders. They will help you cover all these questions so you don’t have to go by what’s on the website alone.

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The Basic Benefits of CFD Trading

When learning how to trade CFDs, you need to know the plus points and negatives and then formulate appropriate trading strategies.

Liquidity – CFD prices exactly reflect the goings-on in the underlying market. CFDs therefore provide you with access to the liquidity in the underlying market, as well as to that of the CFD provider. You can trade on margin – CFDs are a leveraged product, so you need only deposit a fraction of the full value of the trade. This allows you to greatly maximise your returns. You can gain 10 times from an amount put down on a CFD trade compared to another investment. Remember that similarly, losses can also be huge.

Tax-favourable trading – The gearing involved means you can harness a tax-deductible benefit, such as the costs of investing. Interest repayments are normally tax-deductible. Also, you can sell a CFD to control how you’d like to realise a capital gain, which has a bearing on the tax you’ll pay. Low transaction fees – Usually, a CFD brokerage is less expensive than a share-buying service through a full-suite broker. Additionally, the extra cost of holding a long CFD position over a traditional purchase is limited to the interest cost, while a traditional share purchase attracts stamp duty at 0.5% here in the UK. There’s no stamp duty on CFDs since the stock is not actually being purchased.

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The Advanced Benefits of CFD Trading

As you become more sophisticated in CFD trading, you’ll want to harness some advanced benefits. Familiarise yourself with as many as possible when you begin acquainting yourself with how to trade CFDs.

  • Transparency and ease of being able to execute – Trading or investing with CFDs is almost exactly the same as trading with shares, except for the leveraging allowed. One share though usually equals one CFD, so CFDs are not confusing.
  • You can trade long or short equally easily – You can gain from a declining market by taking advantage of share price losses. The CFD trade is on the price fluctuation of a financial asset and does not require you to own it, so selling is as simple as buying, and the structures are identical.
  • You are able to trade international markets and be more diversified from a single account – Many CFD brokers offer CFDs on international shares as well as items you normally can’t trade such as gold, silver, oil, indices, sectors, commodities, treasuries and so on. This helps you attain instant diversification.

Also look out for trading out of hours – look for a broker offering extended hours, so you can trade some markets, such as the Dow or FTSE, after the exchange has closed. CFDs are much less complex than options and warrants. Unlike options or warrants, the CFD price exactly mirrors the price and liquidity of the market.


The Five Primary Rules of Successful CFD Trading

A How to trade CFD guide is a sensible place to start – when it comes to CFDs, you cannot equip yourself with enough knowledge upfront. However, there is also a lot of noise on the subject of how to trade CFDs successfully. Here are five golden rules:

  1. Cut your losses and let your profits run
    This is probably the single reason why more CFD traders are not successful. Clinging to a trade that’s declining coupled with cashing in on a profit prematurely will result in enormous losses and only minor gains.
  2. Leave emotion out of it
    Successful CFD trading is about reason, logical deduction and reasonable foreseeability. A ‘gut feel’ may result in some profit, but to rise above the average, you need to be ruthlessly scientific.
  3. Curtail your single-trade exposure
    The stock market is not a casino. If you speculate 50% or 100% of your capital on a single trade, you have moved from investing to gambling. Smart CFD traders never risk more than 1.5 or 2% of their liquidity.
  4. Build up your knowledge to an advanced level but never forget the basics
    You can never over educate yourself when it comes to CFDs – but don’t become smug. Using a combination of fundamental analysis and technical analysis rather than sticking to just one is best.
  5. Timing is everything
    Entering a trade too early could mean losses even if you were correct in your speculation.


The Equally Important Secondary Rules of Successful CFD Trading

Never compound losing trades. Learn to separate within-range and trending markets. If not, you’ll catastrophically add to a losing trade because of a misguided belief that the price will turn around. Do not forget to read your charts – use trend lines.

Diversification is key. Never losing more than 2% on a single trade does not mean your portfolio is adequately diversified. For example, you may be trading in a spectrum of shares in fast food companies. There are above average odds that if one goes against your bet, so will the others. You should have cross-industry exposure.

Know your strengths and weaknesses. Your psychological constituency and resilience is key. Great CFD traders don’t give in to fear, greed or unfounded anticipation. Trade according to your researched strategy and stay within budget.

Utilise stop losses wisely. Not having a stop loss in place could lead to a swift, unceremonious undoing. On the other hand, if your stop losses are too tight this will also lead to a wipe out over time. You must factor in normal market fluctuations when putting stop loss mechanisms in place.

Understand risk versus reward – you must know the difference. If you’re in a situation where the would-be reward is bigger than the would-be risk, this is in itself too risky a situation to be in. Pursuing reward and avoiding risk are separate issues – never blur the lines.


CFDs are a Great Investment Alternative, but Beware of the Risks

There is a reason so many CFD brokers shout risk disclaimers in all communication as often as they can – there is no doubt that the pitfalls of CFD trading are more dangerous than most other forms of investing. If the thrill of chasing a quick, big profit leaves you unable to think rationally, this form of trading is best avoided.

Yes, the benefits are vast and many as discussed earlier, but also remember that the CFD arm of investing isn’t tightly regulated. Brokers may have a good reputation, but that is not the same as a governmental or huge financial institution standing or having been in business for a century.

Superb CFD brokers exist, but you must thoroughly investigate and vet whether they are presenting a smoke-and-mirrors veneer of meeting your needs, or if this in fact will be the case. Make sure you have mastered other standard norms of investing such as stocks, ETFs, mutual funds and similar products, before venturing into the deep end of the investing pool. With education, a cautious initial approach – pedestrian if need be, and adherence to prudent rules, CFD trading can bring rewards unlike anything else.

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