Whether you are a seasoned investor or a trading novice, you have come across the term CFD trading. CFDs are complex investment products that are often highly leveraged and which offer a unique range of opportunities and risks for all types of traders.
The activity of trading CFDs has been well-established in mainstream financial markets for over two decades now, with the financial derivative being among the most frequently traded products on the planet.
So, what’s a CFD and how does CFD trading work? Here, we take a look at the essentials, from the basics to key CFD trading strategies.
What is a CFD?
A Contract for Difference is not an asset in itself, but rather a derivative of an asset class. It is a contract between a buyer and a seller that allows you to trade on margins without owning an asset outright.
In a similar vein to futures, swaps, and options, CFDs allow you to speculate on the value of assets without the trouble and expense of owning them outright. As the name suggests, a CFD is a contract between two parties, in which each party speculates on the price movements of an asset and agrees to exchange the difference in value.
It is important to emphasise that the value and movements of a contract are not pinned to the underlying value of the asset itself, but rather to the value put upon it by traders and brokers. A CFD is a broad asset class. Traders can buy and sell CFDs in stocks, cryptocurrencies, fiat currencies, metals, equities, and more.
How do CFDs work?
CFDs might sound complicated, but understanding how they work and generate profits is simple and straightforward. In a nutshell, they are a way of speculating on asset markets in order to profit from a particular asset's future value. Depending on the type of CFD trade you execute, you can profit from an increase or a decrease in an asset's value.
This depends on whether you decide to "go long" or "go short" on a trade, which we will cover in greater detail below. A CFD does not involve purchasing shares, commodities, or any type of transaction; instead, two parties agree to each take a position on the future price of an asset. Once you take a position, the contract has begun.
This contract will specify that the broker will either pay or receive the price difference between the opening and the closing of the contract. Let's say you have taken out a CFD with the position that an asset, such as Apple stocks, will rise within a certain timeframe. If this price rise does occur, the other party will pay you the difference between that initial price of the Apple stock and its current value at the time of closing. This is how CFDs work in essence.
What is CFD trading?
So you know what a Contract for Difference is. Now it is worth asking, what is CFD trading? As discussed, CFD trading is the speculation on the future value of an asset, with your profits or losses being derived from the price difference that occurs between the opening and closing of the contract.
However, this is not the full story. CFDs are highly leveraged products, meaning that what you realistically stand to gain or lose is typically much more than just the monetary price difference of an asset. Let's break down the key components of CFD trading in order to better understand the process.
To go long or go short?
As mentioned above, CFDs give you the option to either bet for or against an asset. While this sounds a lot like stock shorting, which is prohibited in many markets, this is not actually the case. That's because it does not involve the ownership of any assets.
The position you decide to take when trading CFDs falls broadly into two categories: long or short. Going long describes the position of a trader who believes a chosen asset will rise in value in the near future. To go long, you would issue a "buy order" on a CFD. If a price rise does occur by the time the contract closes, you can then sell to close the position and collect your profit.
Going short on a CFD sees a trader take a position with the expectation that an asset will decline in value. That's usually over a very short time period, such as a trading day. If you believe the price of the asset will decline in the short term, you can enter a "sell order", and sell when the price drops to a lower level.
Why leverage matters
CFDs are among the most heavily-leveraged products on financial markets today. This has both advantages and disadvantages that will appeal to certain types of traders, especially those with an appetite for high risks and high rewards. The leverage margin means that traders can open much larger positions than their initial cash investment would allow for.
For example, if an asset has a 10% margin and you have £1000 in a brokerage account, you will be able to "buy" up to £10,000 worth of that asset. While this allows you to open a much larger position than your resources would normally allow for, it also exposes you to substantially greater losses.
The weight of this leverage means that even small movements in prices can translate to larger profits or losses, as these movements are multiplied according to your leverage margin.
It is important to note that, with leverage, you can stand to lose more than your initial investment. The broker will be able to request that you add additional funds to your account. This usually occurs if a position moves against you to such a degree that your initial funds cannot cover the difference.
Spreads are crucial
The spread on a CFD is the difference between the price of buying and the price of selling. You enter a trade using the quoted buy price on your brokerage platform, and exit the trade using the quoted sell price. The spread is a cost that you have to bear in mind as a CFD trader. That is why it is important to stick to high liquidity markets, where the spread tends to be lower, thereby maximizing your potential profits, and reducing the size of potential losses.
The more liquidity, the better
The CFD provider or broker provides the liquidity for your transaction. Since you are not dealing with the market directly, nor directly purchasing an asset, you will generally have greater liquidity with CFDs than with many other types of financial derivatives.
Market liquidity affects how quickly you can buy and sell or open and close positions. That makes it essential when dealing with Contacts for Difference, where profits can be generated from the smallest price movements. If there is a low level of market liquidity, you will find it more challenging to sell an asset or close a position.
With CFDs, there remains an added liquidity risk. If there are not enough trades happening around your underlying asset, then your CFD might become illiquid. This is dangerous, as it means that your CFD provider can simply close your contract at an unfavourable price or request extra margin payments in order to keep it open. This is why assets with very high levels of liquidity, such as popular forex pairs, are better suited to CFD trading.
Example of a CFD trade
Let's illustrate what we have covered so far with an example of a CFD trade in action. Let's say you open your brokerage platform and see that HSBC has a buy price of £27.60 and a sell price of £27.59. You might think that HSBC's share price is going to rise in the future and therefore choose to go long, betting on this future price rise.
You could use your leverage to buy 2,000 share CFDs. However, this does not mean you need to pay the full share price, since you are only trading on margin. CFDs are leveraged, meaning that you need to multiply your margin with the exposure. Therefore, if HSBC has a margin factor of 5% then your margin costs would be 5% of your total exposure to the trade.
The cost of 2,000 HSBC shares at £27.60 is £55,200. 5% of this is £2,760, which is how much you would pay. If the share price rises by, say, £2 during the contract period, then your profit would be 2 x 2,000, meaning you would have made £4,000. Conversely, if the share price does not rise in the way you hoped, and drops by £1 in this time period, you will lose 1 x 2,000, meaning a loss of £2,000.
Advantages and disadvantages of CFDs
- CFD trading allows you to take opposite positions from your portfolio, providing a decent hedge against volatility.
- CFDs allow you to quickly execute trades without having to go through the regulations and waiting periods that accompany traditional stock trading.
- The high amount of leverage allows you to open up substantial positions and execute trades that are much larger than you might normally be able to afford.
- CFDs do not involve the purchase of actual assets, meaning UK traders do not have to pay stamp duty on them.
- Leverage also means that you are exposing yourself to potentially substantial losses that you will be expected to accommodate for if a position moves against you.
- Many brokerage firms charge significant commission fees that will damage your profits.
- CFDs are not an asset, meaning that you do not actually own any investments, but are rather just speculating on price fluctuations.
- Illiquidity risks are high in some CFD markets, which can lead to large losses.
How to place a CFD trade
Part of the reason why CFD trading is so immensely popular is that placing a CFD trade is incredibly straightforward. Typically, these are the steps you would have to complete:
- Open your online brokerage account or trading platform.
- Choose a market to trade on, such as forex or equities.
- Do your research on the assets and markets you are interested in.
- Decide whether to hit 'buy' or 'sell'.
- Add a stop loss, which will close your position immediately if a price moves too far against you.
- Monitor your trade and close it at the 'right' time by clicking 'close trade' or 'close position'.
One of the defining features of CFDs is that they tend to be very lightly regulated, especially compared to stocks, bonds, and futures. There are low capital requirements and few regulations governing how much cash you need in a brokerage account.
That being said, recent regulations brought in by the UK's Financial Conduct Authority (FCA) aim to temper the risk of these products. For example, if the funds a trader has in their account are less than 50% of the margin required for an open CFD position, firms are now required to close that account. There are also limits on leverage, which must be between 30:1 and 2:1.
Always choose an FCA-regulated CFD broker if you are based in the UK. Due to the largely unregulated nature of CFDs around the world, they are currently banned in the US. This means US traders cannot currently trade CFDs in any way.
What are the best CFD trading platforms?
Always use a trusted and well-rated CFD trading platform. Some of the best CFD trading platforms on the market right now include:
- The INFINOX Metatrader 4 (MT4) and Metatrader 5 (MT5) platforms
- The eToro CFD trading platform
- Interactive Brokers
What fees can I expect to pay to a brokerage platform?
Most CFD brokerage platforms charge commission fees on executed trades. These can vary substantially, so always choose your platform wisely. In addition, most platforms charge an overnight fee if you are holding your position for more than a single day. Beyond this, there may be admin and deposit fees to consider, so always read the small print.
How do I know what direction a CFD will move in?
Put simply, it is impossible to predict the future. Before opening a position, always conduct thorough research on the markets and assets that interest you. Free resources such as Bloomberg, The Financial Times, and Wall Street Journal can help you better understand current developments in the markets.
How do I reduce risk when trading CFDs?
As we have emphasized, trading CFDs comes with a substantial amount of risk. That is why it is important to do whatever you can to reduce said risk. Simply ways to do this include:
- Always add a stop loss to your account to limit your potential losses.
- Always use an FCA-regulated and trusted brokerage platform, such as INFINOX.
- Manage leverage responsibly and do not treat it as easy, unlimited money.
- Opt for high-liquidity markets so that you do not engage with CFDs that are impossible to shift.
CFD trading can be an exciting experience that can provide you with a crash-course in the minutiae of financial markets. It is a fast-paced form of trading with a very steep learning curve. If it goes your way, the profits can be significant. However, it is crucial to keep in mind the risks of CFD trading and to participate responsibly.