What's in this guide?
- What is CFD trading?
- How can you trade CFDs?
- What CFD trading strategies can I use?
- How do I compare CFD platforms?
- Compare CFD trading accounts
- What are the pros and cons of trading with CFDs?
- Who should trade CFDs?
- Are CFDs a gamble?
- What are some of the risks when trading with CFDs?
- The most important questions about CFD Trading
- CFD and share trading glossary
What is CFD trading?
CFD stands for “contracts for difference”. CFDs let you trade on the price movements of shares, indices, commodities and currencies. 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. CFDs are classed as “derivative” financial products, this means that their value is derived from the value of an asset. Unlike options and futures contracts, CFDs do not have an expiry date.
When you trade CFDs you don’t own the underlying asset, like shares or commodities. This means you don’t have to pay 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 comes with substantial risks attached. With leverage (borrowing), you can end up losing significantly more money than you initially invested. With this in mind, it’s important that you know what you’re doing and that you have an in-depth understanding of the risks involved before you start trading CFDs.
There are loads of technical terms when it comes to trading CFDs and it’s more complex than just buying shares when you think the price is good. Here are the ways that CFDs are generally traded.
Buy in a rising market
If you expect the asset to increase in price then you could “buy” with the “offer” price. This will be the higher of the two prices – the difference is the “spread” which we cover below.
If the asset rises in price, as you expected, then you can then “sell” at the “bid” price. You’ll have made a profit as long as the price rose by more than the spread.
Sell in a falling market
The next option is to “sell” a CFD on an asset that you predict will drop in value. This is done with the “bid” price. If your prediction is correct, you can then “buy” at the “offer” price. You will have made a profit if the value went down by more than the spread. However, if you are wrong and the price of the asset rises, you will suffer a loss.
Using margin and leverage
CFDs are a leveraged financial product. This means that you don’t need to put down the full value of your trade. You only need to outlay a small percentage of the value of an asset when you open a position, this is called the margin. The remaining value is borrowed from the CFD provider, so it’s essentially a loan.
Because of this, it’s entirely possible to lose more than your initial deposit when you invest in CFDs. It’s imperative to ensure that you’re fully aware of your exposure and use tools like stop-loss orders or stop-entry orders to reduce your risk.
like stop loss orders or stop entry orders which can help lessen your risk.
What is the spread? And how does it affect me?
CFD prices are always listed in pairs. There’s a different price depending on whether you want to “buy” or “sell”. There will be a difference between these numbers, sometimes quite small (known as a tight spread) and sometimes quite large (wide spreads).
It helps to look at an example. Lets say that you want to trade a CFD and this is what you see:
The spread is the difference between 6499.5 and 6500.5, which is 1 point (that’s what it’s called, we don’t know why). Let’s say you think the value will go up, in this case, you’ll buy at the offer price.
Now, let’s say the value rises by 5 points over the space of a week. At that point, you’ll see this:
Both “buy” and “sell” prices have risen by 5. The spread is still 1 point. Now, if you want to exit your position, you need to make the opposite action you made before, in this case: “sell”.
When you sell, you don’t completely benefit from the rise of 5 points. As the spread is 1 point, you make a profit of 4 points. Depending on how much each point is worth, and how many contracts you’ve got, you can calculate your profit or loss.
There are two main approaches you can use when trading CFDs:
In either case, when you close the contract, you’ll make the opposite action to your original one. With this action, you want to gain the difference between the opening value of the contract and its closing value – whether that difference is up or down.
Let’s say that 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, Joe Bloggs 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.
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.
Now, let’s say that Daniella has also been monitoring Joe Bloggs Enterprises and believed that the share price was about to go down. She “went short” and sold 4,000 CFDs at £5 each. Like Dan, she has a total contract value of £20,000 and puts down a 5% margin for £1,000. As the shares have gone up, instead of down, as Daniella predicted, she lost her initial £1000 and owes a further £1000.
This is why CFD trading is risky. Leverage allows both Dan and Daniella to borrow £19,000 to purchase their contracts. They are both at risk of losing more money then their initial investment, which Daniella ends up doing.
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.
Consider the following features when comparing CFD platforms:
- Fees and charges. You may 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. Most of the time, fees will be built into the spread.
- 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.
Who should trade CFDs?
CFDs aren’t for the beginner investor. They are complex and come with high risk and a large percentage of users lose money trading CFDs. You need to ensure that you know the risks involved and that you are trading money that you can afford to lose.
Are CFDs a gamble?
Yes, and no. Gambling, in general, is about taking risks with the chance of a positive or desired outcome. As all investing has an element of risk, essentially all trading and investing is a gamble by definition.
However, when it comes to tax, CFDs don’t fall under gambling laws, which means you have to pay capital tax on your income. You can offset your losses against your profits, though, so if you make an overall loss then you wouldn’t pay tax on the gains you do make.
What are some of the risks when trading with CFDs?
Leverage is one of the reasons why CFDs have such high risks attached to them. It essentially allows you to enter a position with only a small percentage of the value (called the margin). The remainder is borrowed from the CFD provider. 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. This means that you won’t receive dividend payments, as you won’t own shares in the company.
You can lose more than your original deposit
Because of leverage, your potential to gain a profit or suffer a loss is far greater than the amount you pay to open a position.
CFD and share trading glossary
- 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.
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