CFDs are among the most versatile derivatives to trade. The following examples demonstrate how you can can use this unique product to profit in rising and falling markets.
- CFDs are an attractive alternative to traditional day trading, allowing you to trade without purchasing assets
- You can profit in both rising and falling markets when trading CFDs
- Leverage allows you to increase your gains (and losses) exponentially
- CFDs exist for a wide range of markets
What Is CFD Trading?
Contracts for difference, usually referred to by the acronym CFDs, are a type of financial derivative that allow traders to speculate on a financial market without having to purchase an underlying asset. Instead, you profit by correctly predicting price movements.
In traditional day trading, you buy and sell an actual financial asset, like stocks, currencies or indices. You may not own much or for very long, but for a short period, you own a specific product.
When you trade CFDs, on the other hand, you never actually buy or sell shares, commodities or whatever financial product underpins your preferred market. Instead, you enter into an agreement with your CFD provider – usually a broker – to buy or sell a certain number of CFDs at a specific price. The price of the CFD corresponds to the price of a specific asset. If the market moves in your favour, you’ll profit when you close your position.
How Does CFD Trading Work?
Let’s look at an example to break down the mechanics of how a CFD trade works.
Alex, an experienced trader, decides to open a CFD position with his broker CMC Markets. He’s been closely monitoring the stock price of a well-known tech company, XYZ Inc., and strongly believes that the price will rise in the near term.
Alex logs into his CMC Markets trading account and selects the CFD product for XYZ Inc. The current price is £100 per share. As he’s decided to go long, he places an order to buy 1,000 CFDs. He’s also using leverage to enlarge his position at a margin of 10:1. That means he can put down £10,000 to open a CFD position with £100,000 (1,000 CFDs * £100 per share multiplied by a factor of ten).
Over the course of the next few days, a positive earnings report and favourable market sentiment push the price of XYZ Inc.’s shares up to £110 per share. This is great news for Alex, who logs into his CMC Markets account and places an order to sell his 1,000 CFDs.
By selling when the market is high, Alex nets himself a profit of £10,000. That’s the difference between the £100,000 he paid to buy his XYZ, Inc. CFDs and the £110,000 for which he sold them.
Notice that at no point did Alex ever buy any shares of XYZ Inc. He simply predicted that the price of its shares would rise and placed a bet with his broker. Because Alex correctly predicted the market movement, he made money.
Types of CFDs
Because a CFD depends on market movement rather than a specific asset class or financial instrument, it’s a broad category of trading product. In other words, if a market exists where you can trade a financial asset, you can usually also purchase CFDs for that asset.
Popular CFDs amongst UK traders include:
- Cryptocurrency CFDs
- Commodity CFDs
- Stock CFDs
- Forex CFDs
- Index CFDs
- Bond CFDs
Whatever CFD you opt to trade, spend time learning the fundamentals of market analysis. Even better, focus on CFDs in markets with which you’re already familiar. If you’ve spent years day trading shares, for example, stock CFDs make a natural choice. Forex traders interested in diversifying their portfolios might look into currency CFDS.
Remember Alex, our lucky CFD trader? Let’s keep following him for a few more imaginary trades to understand how winning and losing trades work when buying or selling.
CFD Trading Example 1: Buying
In these examples, we’ll look at what happens when Alex bets that the price of an asset will rise and buys CFDs. Some traders call this ‘going long’.
Winning CFD Trade
For an example of a winning long trade, take a look at the example above. Alex bet that XYz, Inc. would increase in price, and so purchased 1,000 CFDs. He read the market correctly and, when the value increased, sold them at a profit.
Even better, because Alex had access to leverage, he was able to purchase more CFDs than he would have if limited to his trading account balance. As a consequence, he also enjoyed larger profits.
Losing CFD Trade
Let’s say that, instead of a favourable market report, XYZ, Inc. discloses significant internal cutbacks and budgetary constraints. Far from rising, the price of its shares begins to drop.
Alex waits for a day or two in hopes of a rally, but decides to cut his losses when the price hits £90 per share. He logs into his account and places an order to sell his 1,000 CFDs. Alex incurs a loss of £10,000, which the broker deducts from his trading account.
Fortunately, Alex has the funds to cover his loss. Had he not, his broker might have issued a ‘margin call’ as his losses approached the value of his account balance and forcibly closed his position. When you trade with margin, you borrow money from your broker, and it reserves the right to protect itself.
CFD Trading Example 2: Selling
Now, let’s turn the tables to consider how CFD trading works when you decide to ‘go short’ on an asset and bet that the price will fall.
Winning CFD Trade
Alex has been following the news and has good reason to believe that the price of tech stocks will soon decline. In particular, he thinks that the price of Acme Corp’s shares will fall dramatically based on sluggish sales during the most recent quarter.
On the basis of this analysis, he logs into his account and places an order to sell 1,000 CFDs of Acme Corp at the current share price of £100 per share. In fact, he’s so confident in his analysis that he uses margin of 10:1 to enlarge his position to £100,000.
Note that Alex doesn’t actually own any shares of Acme Corp to sell. His ‘sell’ order here functions as a bet that the price will fall, at which point he’ll pocket the difference between the open and closing prices.
Following a disastrous quarterly earning report, the price of Acme Corp’s shares drops to £90 per share. Alex logs into his trading account and places a ‘buy’ order for 1,000 CFDs. The buy order serves to close his position, at which point he profits to the tune of £10,000.
Losing CFD Trade
Now imagine that, instead of falling, the price of Acme Corp shares rallies unexpectedly on the back of a surprisingly optimistic earning report and a new product launch. When Alex realises that the market has moved against him, he rushes to close out his position.
Upon logging into his account, he sees that one share of Acme Corp now sells for £110. He places a ‘buy’ order for the current market price and absorbs his loss of £10,000.
- Trading CFDs offers an appealing alternative to traditional day trading, as it doesn’t require the purchase of assets.
- CFDs enable you to profit in markets that are both rising and falling.
- The use of leverage in CFD trading allows for exponential gains (and losses).
- CFDs are available for a diverse array of markets.
Frequently Asked Questions
Can you make money trading CFDs?
Yes. Many CFD traders enjoy financial gains from their trading. That said, don’t put money in the markets that you can’t afford to lose, especially when you start trading.
Be aware, too, that you will pay taxes on your CFD trading profits. Unlike spread betting, which HMRC considers gambling, your CFD trade winnings are subject to stamp tax and capital gains tax.
You can read more about the pros and cons of CFD trading here.
How to choose a CFD trading platform?
With so many reputable brokers, each with a variety of CFD trading platforms on offer, choosing the best platform for your trading strategy can feel overwhelming.
When in doubt, consider your overall trading objectives and your preferred style. For example, if you’re also interested in forex trading, MetaTrader 4 is the logical choice. On the other hand, if you dabble in traditional share trading on a centralised exchange, you’ll want access to MetaTrader 5. Traders who rely extensively on advanced charting might be interested in TradingView.
What is the best CFD broker?
Similar to CFD trading platforms, the best CFD broker for you will depend on a number of factors, including your budget, trading strategy, leverage needs and desired trading platform.
Regardless of your other trading needs, I always recommend trading with a regulated broker licensed in your jurisdiction. As a UK resident, look for evidence that the Financial Conduct Authority (FCA) oversees your CFD provider.
Trading CFDs vs Spread Betting?
While both CFD trading and spread betting allow you to speculate on price movement without purchasing a financial asset, they differ in several key respects.
The two most significant: tax treatment and trading costs. As mentioned above, HMRC treats spread betting profits as gambling winnings, which means you won’t pay tax. CFD trading profits, on the other hand, are subject to capital gains and stamp tax.
When spread betting, you pay on the spread when executing your trade. (Remember, the spread is the difference between the ask price and the sell price for a given asset and can vary significantly.) With CFD trading, you may have the option of a spread-only pricing model, but many traders prefer to pay commissions to their brokers in exchange for tight minimum spreads.
CFD Trading vs Share Trading?
CFD trading and share trading have superficial similarities but are fundamentally different creatures. In share trading, forex trading and other forms of retail investing, you purchase the underlying asset. CFD trading, by contrast, involves only speculating on price movements in financial markets.
Don’t be fooled by lookalike account structures, trading platforms and pricing models. Trading shares and trading CFDs require different skill sets and strategies for success.