Contract for Difference trading is a dynamic and accessible way to engage with financial markets. Whether you’re a seasoned trader looking to diversify your portfolio or a newcomer seeking to understand the basics, we’ll provide a clear and concise overview in this article. Discover how CFDs enable you to speculate on price movements across various assets without the risks of ownership.
- Contracts for difference allow you to speculate on market movements without the risk of owning the underlying asset
- Trading CFDs is safe and legal, provided you develop a risk management strategy and trade with a licensed, reputable broker
- CFD trading allows you to enlarge your margin, and your profits, with margin
- You can trade CFDs across almost any asset class
What is a contract for difference (CFD)?
As the name suggests, a contract for difference (CFD) is an agreement between two parties that allows them to speculate on the price movement of a financial instrument without purchasing the underlying asset. When the contract closes, one party pays the other the difference between the opening and closing price.
How does this work in practice? When a trader opens a position, he enters into a contract with his broker. If the trader has correctly predicted how the market will move, the broker will pay him the price difference when he closes his position and ends the contract.
How does CFD trading work?
Trading CFDs allows you to speculate on the price of a financial instrument without actually purchasing the underlying asset. That is, you can bet that the price of a commodity or share to rise or fall without having to purchase the commodity or share.
This is where a CFD trade differs significantly from a traditional trade. For example, if you trade stocks, you purchase actual company shares. You own a small portion of Acme Corp or XYC LLC for a brief period. If you trade a share CFD, on the other hand, you don’t actually buy or sell anything. Instead, you agree with your CFD provider to either pay – or be paid – the difference between the opening and closing price of your position.
CFD Trading Example
Need an example of how a CFD trade works in the wild? Let’s walk through the process.
Alex wants to bet on the price of Acme Corp’s stock without actually buying shares. Instead, he opens a trading account with a reputable CFD provider, IC Markets. Alex believes that the price of Acme Corp will rise, so he buys 1,000 CFDs at the current price of £100 per share. The total size of Alex’s position works out to £100,000 (1,000 CFDs x £100 = £100,000).
Alex accurately predicted the price movement of Acme Corp. When the share price rises to £110 per share, he closes his position at a profit of £10,000. The £10,000 represents the difference between the closing value of £110,000 and the opening value of £100,000.
Of course, Alex will need to pay IC Markets a fee for executing his trade. Depending on the type of trading account, he’ll either pay the spread set by IC Markets or a flat commission. (The spread represents the difference between the buying price and selling price of a trading asset.)
View the CFD trading example page for more simulated trade scenarios.
Advantages of CFDs?
While there are risks associated with trading CFDs, this particular trading instrument also comes with some significant advantages. View our CFD pros and cons for a more comprehensive analysis.
Most reputable CFD providers, including top brokers like CMC Markets, IG Markets and City Index allow you to enlarge your position with leverage. Also known as ‘margin trading’, trading CFDs with leverage means you borrow money from your broker to purchase more CFDs than you could otherwise afford with the money in your trading account.
Remember Alex? Let’s say he’s so confident in his market analysis that he wants to purchase £10,000 worth of Acme Corp CFDs. Because his broker offers leverage of up to 10:1, he’s able to open the position with just the £1,000 in his trading account.
Diverse Asset Selection
Both beginner traders and seasoned experts can benefit from the flexibility and variety CFD trading offers. CFDs cover a wide range of asset classes, from commodities to shares to indices to currencies. If you’re looking for options to diversify your portfolio, CFD trading may be just the ticket.
Access to Global Financial Markets
Trading CFDs gives you the opportunity to explore financial markets or assets you might not otherwise be able to access directly.
Provided your CFD provider allows it, you can use CFD trading to hedge against potential losses in other positions. For example, if you’ve gone long on a specific commodity CFD, you might opt to short a related share CFD to cover yourself.
The wide variety of available assets makes it easier to find an appropriate position to counterbalance another, making for an alternative form of risk management.
Disadvantages of CFDs?
The risks of trading CFDs are real, and it’s important to understand the possible downsides before venturing into this type of retail investing.
While margin trading has the potential to increase profits exponentially, it can also lead to sizeable losses.
In the event that the market moves against you and your CFD trade goes bad, your broker may issue a margin call and a stop out to prevent you from incurring catastrophic losses. That won’t, however, stop you from losing the entire value of your trading account.
Trading CFDs can have a steep learning curve, and it’s important to start slowly and with an appropriate risk management system in place to protect yourself. Likewise, you’ll need to practice self-discipline to avoid impulsive over-trading.
Most CFD providers offer two pricing models, both of which incorporate the spread. While some account types may offer tighter spreads than others, the quoted minimums aren’t constant. Volatile market conditions can widen variable spreads and eat into your profits.
What are the costs of CFD trading?
Generally speaking, the cost of trading CFDs fall into two categories; direct and indirect.
- Direct trading costs. These are the costs of trading CFDs (or forex, or any other financial instrument) that arise immediately out of executing and managing trades. Examples include spreads, commissions and swaps.
- Indirect trading costs. Sometimes called ‘hidden costs’, these are the fees you pay to your broker in order to maintain your account. Examples include deposit and withdrawal fees or minimum deposits. You might also count market-induced expenses like slippage as indirect trading costs.
It’s important to carefully assess your risk appetite and trading budget before you begin trading CFDs. We also recommend that you begin trading by opening a demo account, which allows you to hone your trading strategy with virtual funds.
- CFD trading enables speculation on market movements without the need to own the underlying asset, mitigating ownership risk.
- Trading CFDs is both safe and legal when done through a licensed and reputable broker, contingent on the development of a sound risk management strategy.
- CFD trading offers the advantage of margin, allowing you to amplify your margin and potential profits.
- CFDs can be traded across a wide range of asset classes, providing extensive market coverage.
Frequently Asked Questions
Best CFD broker?
The best CFD provider for you will depend on a number of factors, from your preferred trading strategy to your desired trading platform to your budget. If, for example, you’d also like to trade forex and intend to rely heavily on trading bots, you’ll want to look for a broker that offers Metatrader 4. On the other hand, if you’re a casual trader more interested in social and copy trading or cryptocurrencies, you’ll want to look at a broker like eToro.
Is trading CFDs safe?
Any online trading activity carries a certain degree of risk. The same market volatility that delivers exceptional returns can also deliver exceptional losses.
The best way to control against market volatility? A carefully-planned risk management strategy that incorporates hedging and, where available, guaranteed stop-loss orders. You can also protect yourself by trading with a regulated broker licensed by the Financial Conduct Authority. While this won’t guarantee that you don’t lose money on trades, it does ensure that your broker won’t misuse your funds.
Can beginners trade CFDs?
Yes, and CFDs can be an excellent way for new traders to develop their skills. The variety of financial markets available and the range of trading platforms designed for CFDs make them a great way to experiment.
That said, beginners should exercise caution and take care not to overextend themselves.
Can you make money trading CFDs?
Yes, you can make money trading CFDs. You can, of course, also lose money trading CFDs, and it’s important to understand the risks and benefits before opening an account.