What is CFD trading?
CFD stands for ‘Contracts for Difference’. CFDs allow you to trade on the price movements of financial instruments such as shares, indices, commodities and currencies.
When you trade CFDs you don’t own the underlying asset, for example shares in a company, meaning you don’t have to worry about any account management fees and the like. Instead, you borrow money to bet on the short-term rise or fall of a financial instrument such as shares in a company. If your prediction is right, you can make a profit; if your prediction is wrong, you can suffer a loss.
CFDs are becoming an increasingly popular trading option for investors in the UK and around the world. This is largely because they offer the potential to enjoy substantial gains without a high starting amount. This rise in popularity is reflected by the increasing number of online brokers making it possible for investors to trade CFDs from the comfort of their own home.
However, CFD trading does come with a number of substantial risks attached. What some investors don’t realise is that because you’re using leverage to bet on the value of an underlying asset, you can actually end up losing a significantly larger amount of money than you initially invested. With this in mind, it’s important that you know what you’re doing and have an in-depth understanding of the risks involved before you start trading CFDs.
Buying in a rising market
If you buy a CFD on an asset that you expect to increase in price and your prediction is right, you can then sell the CFD at a profit. However, if the product falls in price, you will make a loss.
Selling in a falling market
The next option is to sell a CFD on an asset that you predict will drop in value. If your prediction is correct, you can then purchase the CFD back later at a lower price. However, when you are wrong and the price of the asset rises, you will suffer a loss.
As CFDs are a leveraged financial product, you only need to outlay a small percentage of the value of an asset when you open a position. It’s entirely possible to lose more than your initial deposit when you invest in CFDs, so make sure you’re fully aware of your exposure and use tools like stop loss orders or stop entry orders which can help lessen your risk.
When you start trading on CFD markets you will see that CFD prices are listed in pairs, and the spread refers to the difference between the buy price and the sell price of a contract. If you believe the price is going to fall, the sell price is the one that applies to you. If you believe the value will increase, use the buy price.
Trading contracts for difference is quite complicated and is suited for experienced investors. It’s important to clarify that when you trade CFDs, you don’t actually buy the underlying asset, such as shares. While traditional share trading involves aiming to make a profit through dividend payments or the rise in value of shares you own, CFDs involve betting on which way the price of a particular share will move.
With every CFD there is a buyer and a seller who enter into a contract. As long as that contract remains open, both parties are exposed from a financial point of view to any changes in the value of the underlying asset. CFDs can be traded on a wide range of underlying assets, including shares, commodities, foreign exchange pairs and market indexes.
Because they derive their value from the value of another asset, CFDs are classed as ‘derivative’ financial products. Unlike options and futures contracts, CFDs do not have an expiry date.
There are two main approaches you can use when trading CFDs:
- Going long. This means buying a CFD in the expectation that the underlying CFD will increase in value. You can then sell at a profit if your prediction is proved to be correct.
- Going short. This strategy involves selling a CFD because you believe the underlying CFD will decrease in value. If this prediction is correct and the price drops, you can buy the product back in future at a lower price.
In either case, when you eventually close the contract, you want to gain the difference between the opening value of the contract and its closing value – whether that difference is up or down.
For example, you might choose to go long and take out a CFD over a particular company’s shares. If you open a position with a value of £10,000, you’ll only be required to pay an initial margin or collateral to the issuer of the CFD, which in this case is £500, or 5% of your overall exposure.
If your expectations are correct and the company’s share price rises, the seller of the CFD must pay you the difference between the current share price and the price they were at when you took out the contract.
On the flipside, however, if the shares drop in price then you will need to pay the issuer the difference. If prices drop substantially, you can end up owing much more than you originally invested. It’s important that you’re fully aware of this risk before you decide to start trading CFDs.
Dan's CFD trading journey
With more than 10 years of experience in the banking and finance industry, Dan has decided he would like to start trading CFDs. After hunting around for a trading platform that offers the features he wants, Dan decides that a company he has been monitoring, DAN DAN Enterprises, is set to experience a big jump in its share price, so he ‘goes long’ and buys 4,000 CFDs at £5 each – that means a total contract value of £20,000.
The CFD provider requires a 5% margin in order to open a trade, so this amount (£1,000) is deducted from Dan’s account. A 0.15% commission of £30 is also charged by the CFD provider.
Happily for Dan, the shares jump a massive 10% from £5 to £5.50, which sees Dan gain close to £2,000, almost doubling his initial investment.
If the shares fell by 10% instead, Dan would have lost his initial £1000 and would owe a further £1000.
In terms of trading strategies, there is a huge selection of approaches you can adopt. For example, you may wish to hedge a single stock by selling a CFD for every share you hold in a company. This can then offset any losses you sustain due to the fall in value of the underlying asset.
Another common approach is to engage in pairs trading with two historically similar stocks, such as shares in two banks. When the price of shares in one bank temporarily weakens against the price of those in another, you can then long the under performing stock and short the other one, taking the gamble that the spread between the two will eventually come closer together.Back to top
Consider the following features when comparing CFD platforms:
- Fees and charges. You’ll need to pay fees to a trading platform provider in order to trade CFDs and access markets. You’ll be charged for every trade you place and the trade will vary between providers, while you may also have to pay fees to access additional research data. Some platforms will charge interest on long CFD positions that are held open overnight, so make sure you’re aware of all the fees that may apply to your account.
- Market data. What data does the trading platform make available about the market and the performance of underlying assets? Do you need to pay a fee to access this data?
- Research tools. Consider the research tools available if you want to research companies, share prices and the performance of the market in general. These tools can help you make informed trading decisions.
- Ease of use. Look for a platform that is easy and intuitive to use. Many platforms will let you open a demo account to sample their services, and these can be very useful when making your final decision.
- Trading methods. In addition to trading online via your PC, can you lodge trades over the phone or through an app on your tablet or mobile device?
- Margin requirements. In order to open a CFD, you’ll need to pay a margin – this is a percentage of the total value of the trade. Margin requirements vary between providers.
- Margin calls. If you have an open trade that has lost money and there are not enough funds in your account to cover your debt, a CFD provider will make a margin call. While some providers will alert you to notify you of your margin call requirements, others will not and will instead place the responsibility on you to monitor your account.
- You don’t have to worry about ownership costs such as account management fees.
- Because you are trading with leverage, you can get started with fewer funds than if you had to purchase the underlying asset.
- Big financial gains are possible when trading CFDs.
- You can enjoy the convenience of managing all your CFD trades from home with a user-friendly platform.
- Trading CFDs is a high-risk investment strategy.
- You can lose more than your original investment.
- Counterparty risk – the CFD provider may fail to meet their obligations to you.
- Changing market conditions and the technical capabilities of the trading platform you use may mean you are unable to place trades at the time you wish.
- Large gains are often offset by equally large losses.
It’s important that you realise that CFD trading is a complex investment option which carries a very high level of risk. This form of trading is not suitable for every investor.
It’s your responsibility to decide whether or not you’re capable of successfully trading CFDs and you shouldn’t even start trading CFDs unless you fully understand the associated risks.
With CFDs, you have the option of choosing to cover only a small margin of the value of the underlying asset in order to open a position. For instance, if you buy £5,000 worth of ABC CFDs that have a margin of 5%, you only need to provide a margin of £250 to open the position. The rest of the value of the asset is covered by the CFD provider. However, the level of risk you are exposed to is identical to if you’d purchased £5,000 worth of shares at their full value. This means that any changes in the market will have a greater impact on the money you have invested than would be the case if you had simply bought shares in the traditional manner.
You’re not buying or trading the underlying asset
A CFD is a contract between you and the CFD provider. Rising or falling prices can result in a profit or loss for you, and it’s important to understand that you’re not buying the underlying asset.
You can lose more than your original deposit
When you trade CFDs you are only required to pay a small percentage of your total exposure upfront – this is known as margin. However, your potential to gain a profit or suffer a loss is far greater than the amount you pay to open a position.
- Ask or Ask price. This is the price at which you can buy CFDs
- Bid or bid price. This is the price at which you can sell CFDs
- CFD (Contract for difference). This is a contract entered into by two parties who agree to exchange money according to the change in value of an underlying asset.
- Contract currency. This is the currency in which a particular asset is traded.
- Dealing. Dealing is when you open or close a CFD position.
- Derivative. A financial instrument whose price is derived from an underlying asset.
- Going long. When you open a buy position.
- Going short. When you open a sell position.
- Hedging. Taking an opposite position to reduce the risk associated with an initial position.
- Initial margin. This is the minimum deposit required when you wish to open a CFD position.
- Leverage. Leverage allows you to trade a larger value asset than the worth of your initial investment. This is sometimes also referred to as gearing.
- Open interest. This is the interest rate that applies to all CFD positions that are held open overnight.
- Stop-loss. A stop-loss order can be placed when a CFD position is opened and is triggered when the price reaches a specified level. These orders are used to close out positions that have resulted in a loss and aim to prevent further loss.
Warning: Spread bets and CFDs are leveraged products and can result in losses that exceed deposits. The value of shares, ETFs and ETCs bought through a share dealing account, a stocks and shares ISA or a SIPP can fall as well as rise, which could mean getting back less than you originally put in. Please ensure you fully understand the risks and take care to manage your exposure.