What Is CFD Trading?November 10, 2021
A CFD stands for contract for difference. CFD trading allows you to take a position on the price of an instrument without actually owning the underlying asset. One of the most unique aspects of CFDs is that they enable you to profit from falling markets as well as rising ones.
In this post you can learn:
- What CFDs are and the benefits and risks of trading them
- What leverage is and how to use it in practice
- What makes CFDs so popular
What Are CFDs?
Let’s first address the most basic question: what is a CFD? The term CFD stands for contracts for difference.
A contract for difference creates, as its name suggests, a contract between two parties (typically described as ‘buyer’ and ‘seller’) on the movement of an asset price.
There are several key features of CFDs that make them a unique and exciting product:
- CFDs are a derivatives product
- CFDs are leveraged
- You can profit and incur losses from both rising and falling prices
Why Are CFDs a ‘Derivatives’ Product?
The term ‘derivatives product’ simply means that when trading CFDs, you don’t actually own the underlying asset. You’re simply speculating on whether the price will rise or fall. When you trade a CFD, you are agreeing to exchange the difference in the price of an asset from the moment the contract is opened, to the moment it’s closed.
Let’s take stock investing as an example. You’d like to purchase 10,000 shares of Barclays and its share price is 280p, which means that the total investment would cost you £28,000, not including the commission or other fees your broker would charge for the transaction. In exchange for this, you receive a stock certificate, legal documentation that certifies ownership of shares. In other words, you have something physical to hold in your hands until you decide to sell them, preferably for a profit.
With CFDs, however, you don’t own those Barclays shares. You’re simply speculating, and potentially profiting, from the same movements in share price.
What Is Leverage in CFD Trading?
Leverage means you gain a much larger market exposure for a relatively small initial deposit. In other words, your return on your investment is significantly larger than in other forms of trading.
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Let’s go back to the Barclays example. Those 10,000 shares of Barclays are at 280p, costing you £28,000 and not including any additional fees or commissions.
With CFD trading, however, you only need a small percentage of the total trade value to open the position and maintain the same level of exposure. Let’s suppose that a broker gives you 5:1 (or 20%) leverage on Barclays shares. This means that you would only need to deposit an initial £5,600 to trade the same amount.
If Barclays shares rise 10% to 308p, the value of the position is now £30,800. So with an initial deposit of just £5,600, this CFD trade has made a profit of £2,800. That’s a 50% return on your investment, compared to just a 10% return if the shares were bought physically.
The important thing to remember about leverage, however, is that while it can magnify your profits, your losses are also magnified in the same way. So if prices move against you, you may be closed out of your position by a margin call or have to top up your funds to keep it open. This is why it’s important to understand how to manage your risk.
If Barclays shares fall 10% to 252p, the value of the position is now £25,200. So with an initial deposit of just £5,600, this CFD trade has made a loss of £2,800. That’s a -50% loss on your investment, compared to just a -10% loss if the shares were bought physically.
What Is ‘Trading on Margin’ with CFDs?
Trading on margin is simply another term to describe leveraged trading, because the amount of money required to open and maintain a leveraged position is called the ‘margin’.
How Do CFDs Work?
Now that you know what CFDs are, let’s take a closer look at how CFDs work. To understand how CFDs work, it’s important to have a good grasp of the following concepts, and how they apply to CFD trading:
- Spread and commission
- Deal size
Spread and Commission
CFDs are quoted in two prices: the buy price and the sell price, and allow you to profit from both rising and falling prices.
- If you believe the price of an asset is going to rise, you go long or ‘buy’ and you’ll profit from every increase in price.
- If you believe the price of an asset is going to fall, you go short or ‘sell’ and you’ll profit from every fall in price.
Of course, if the markets don’t move in the direction you expect, you’ll suffer a loss.
So, if you believe, for example, that Apple’s share price will fall in value, you simply go short on Apple share CFDs and your profits will rise in line with any fall in price below your opening level. However, should Apple’s share price actually rise, you would suffer a loss for every rise in price. How much you profit or lose will depend on your position size (lot size) and the size of the market price movement.
The ability to go long or short, along with the fact that CFDs are a leveraged product, makes CFDs one of the most flexible and popular ways of trading short term movement in financial markets today.
Trading CFDs is more similar to traditional trading than other derivatives, such as spread bets or options. This is largely due to the fact that CFDs are traded in standardised contracts, or lots. The size of an individual lot depends on the underlying asset being traded, often mimicking how that asset is traded on the market.
Duration of the Trade
More often than not, CFD trades have no fixed expiry. A position can be closed simply by placing a trade in the opposite direction to the one that opened it.