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What is CFD trading

 

If you want to be able to make short and long market trades with simplicity and speed, then CFDs can be an effective way to meet your financial goals.

So, what is CFD trading?

CFD stands for Contract For Difference.

When you enter into a CFD, you and a broker agree to exchange the difference between an asset’s price when you open the trade and the asset’s price when you close the trade.

CFDs can be a powerful tool, but it’s important you understand them thoroughly before you start trading.

In this in-depth guide, we’ll answer a number of CFD FAQs, including:

  • What is a contract for difference?
  • How can you benefit from trading CFDs?
  • What are the risks you need to understand when trading CFDs?
  • What does ‘underlying asset’ mean, and how does it relate to your CFD trades?
  • Can you trade CFDs without leverage?
  • What are the additional costs you might incur when trading CFDs?
  • Are CFDs safe?
  • Are CFDs legal?

We’re also going to show you how to practise trading both long and short CFDs without risking any real money. If you want to become a more knowledgeable, confident trader, keep reading.

 

So, what is a contract for difference?

A CFD is an agreement between you and a broker to exchange the difference in an asset’s value between:

  • The price when the contract opens, and
  • The price when the contract closes

The difference between the two values will be either your profit or your loss, depending on how you choose to enter the contract.

Let’s go through a step-by-step CFD trading example.

  • You believe that the price of silver is going to go up in the next 24 hours
  • The price of a ‘lot’ of silver is currently $200. (‘Lots’ are how CFD trades are measured. Don’t worry, we’ll explain them in full in a minute)
  • You decide to trade the value of 10 lots
  • The price of silver rises to be worth $250
  • The difference between the price at the start of the contract and the end is $50
  • You traded the value of 10 lots, so your profit on this trade is $500

Had the price of a ‘lot’ of silver fallen to be worth $150, you would have lost $500.

 

Are you a buyer or a seller?

 

What is CFD trading

 

You can choose to enter a contract for difference in two ways: as a buyer or as a seller.                      
 

Understanding this is quite simple:                    
If you believe the price will go up, you want to be the buyer. If you buy a stock for $200, and it increases in price to $250, you can sell it back and make $50 in profit.                     
 

If you believe the price will go down, you want to be the seller. If you sell a stock for $250, and it falls to $200, you can buy the stock back for less than you sold it for, and again the $50 is profit.

Though you don’t actually own the stocks when you trade CFDs, the principle is the same.

 

Let’s go through an example:

You decide to take out 10 CFD contracts on Company A’s stock, which is worth $250 per share.

10 contracts gives you a total trade size of $2500.

The share price then increases to $300 per share.

Your profit per contract is $50, so your total profit is $500.

 

What are the benefits of trading CFDs?

 

What is CFD trading

 

Benefit 1 – CFDs make it simple to go long or short on your trade

If you believe an asset is about to fall in value, as we’ve just covered, you may want to place a ‘short’ trade.

This means that if you’re correct and the asset falls in value, you will profit from the decline in price rather than losing money.

Unfortunately, short selling in the traditional investing sense can be quite complex. You will need to arrange borrowing the stock or asset you wish to short, and you’ll need to find a buyer. There are also multiple fees and charges to consider.

This can make short-selling intimidating, to say the least. (You can read our full guide on short selling here.)

When you trade CFDs, however, placing a short trade is no different in a technical sense than placing a ‘long’ position.

Here’s a snapshot we’ve taken from the markets.com trading platform:

 

Snapshot of Apple Stock being traded.

 

Once you’ve inputted the number of units you’d like to trade in the central box, placing your trade is simply a matter of clicking:

  • The left hand ‘Sell’ button if you want to go short. (You believe the price will fall.)
  • The right hand ‘Buy’ button if you want to go long. (You believe the price will rise.)

You’ll then be taken through to the next screen, where you can add the specifics of the trade.

The ability to short or long on a trade with the same ease can be a major benefit for traders who regularly do both.

 

Benefit 2 - CFDs allow you to trade a wide number of assets

It’s possible to trade a wide range of market assets using CFDs, including:

*Crypto currency CFDs are prohibited in some countries, such as the UK.

markets.com alone has more than 3,000 instruments ready for you to trade on our CFD trading app.

Whatever trading strategy you want to follow, and however you want to diversify, you should be able to achieve your goals using CFDs.

 

Choose your points of movement

Сalculate your hypothetical P/L (aggregated cost and charges) if you had opened a trade today.

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Past performance is not a reliable indicator of future results.

All positions on instruments denominated in a currency that is different from your account currency, will be subject to a conversion fee at the position exit as well.

Benefit 3 - CFDs allow you to access the market with less capital, by using leverage

CFDs use leverage, which means that as a trader, you won’t require as much capital to place a trade as you might when placing a normal investment.

 

Here’s an example.

Your broker has agreed to let you access leverage of 20:1.

You want to place a trade on the price of gold, which is currently standing at £1600.

You place a CFD trade for 3 ‘lots’, meaning the trade is valued at £4800.

By using leverage of 20:1, you can place this trade using £240 of initial capital.

If the value of your trade rises to be worth £5200, you make a profit of £400.

Had the value of your trade fallen to £4400, you would have lost £400, despite your initial capital injection being worth only £240.

This last point is important. One of the key risks of using leverage – one that we’ll explore in more depth further down the page – is that you can lose more than your initial stake.

 

The amount of leverage you can access – and how much you choose to use – will depend on a number of factors, including:

  • The value of the asset
  • The liquidity of the asset
  • Your personal appetite for risk
  • Your financial resources
  • The broker’s individual preferences

 

CFD Benefit 4 – Diversification (again, due to leverage)

By giving you the option to place trades with less initial capital, CFDs can help you diversify your trading positions.

 

Here’s another CFD trading example:

You believe that UK stocks are set to increase in value over the next week.

So, you choose to place a long trade on the FTSE 100 index. For the sake of this example, a share of the FTSE 100 index is currently valued at £8,000.

But what if you only have £8,000 to invest in total?

Well, by using leverage of 10:1, you can open an £8,000 position in the FTSE 100 using just £800 of your capital.

This means you could use some of your remaining capital to place a similar size trade in an asset like UK Government Bonds. (Many traders see bonds as a ‘safe haven’ asset, which means they will often rise in value as stocks fall in price.)

By doing so, you give yourself an opportunity to offset losses on your FTSE 100 position, something you couldn’t do if you had to use all your capital just to place that single trade.

 

An Important Note. When trading CFDs, you do not own the underlying asset.

We’ve talked here about placing ‘trades’ using CFDs. It’s important to understand, though, that trading CFDs is different to placing traditional trades. 

When you place a CFD trade, you are not actually buying the underlying asset. 

A CFD is what’s known as a ‘derivative’ financial product. As in, the value of the trade ‘derives’ from the price of the underlying asset.

So, opening a CFD on the price of 100 shares of Apple is not the same as actually buying those 100 shares. You don’t become an Apple shareholder. 

The only contract is between you and the CFD broker. 

(This means that you will not be entitled to shareholder benefits. Though in some cases dividend payments may be ‘factored in’ to the value of your CFD contract. For a detailed guide on the specifics of dividends within CFD contracts)

 

 

So, what are the risks of holding CFDs?

 

CFD Risk 1 - Some trades will lose you money

All trading carries risk. No investment of any kind is guaranteed to make you money.

If you’re not comfortable with the idea that some of your trades will lose money, you shouldn’t be trading at all.

As legendary trader Paul Tudor Jones once put it: “Trading is very competitive, and you have to be able to handle getting your butt kicked.”

All traders – even the very best ones – make the wrong calls and lose money sometimes. The key is to have a risk strategy in place that cuts losses quickly. Then, if you maximise profit from your good trades, you can become profitable over time.

And remember, not all losses are created equal.

If you place an unleveraged long trade, for instance, your losses are inherently limited because the most any asset price can fall is to zero.

Short trades, conversely, are essentially limitless. There’s no limit to how much the asset’s price can increase by. This means that if you trade against, it, your losses can be technically infinite.

 

CFD Risk 2 - Leverage can multiply your losses

Earlier, we talked about how you can use leverage to your benefit when trading.

Now, it’s time to talk about the flip side of the coin. The fact that while leverage can ‘amplify’ your gains, it can also amplify your losses.

You can in fact lose more than your initial capital if the markets move against you.

 

Let’s look at an example:

You’ve entered a trade worth £40,000, but by using leverage you’ve only actually used £500 of your capital. (Leverage of 40:1)

When using leverage, any losses or gains are calculated on the total value of the trade, not the amount of capital.

So, let’s say your trade grows by 20%. The total value of your trade hits £48,000. In this case, your profit would be £8,000. (From £500 of capital.)

However, if the value of the trade fell by 20%, the total position size would fall to be worth £32,000.

In this case, you would lose £8,000. Again, despite having only invested £500.

This is what we mean when we say leverage can cause you to lose more than your initial stake.

 

And remember, if this was a short trade, there would be no limit to your potential losses.

This level of risk is why many investors choose not to use leverage at all. They simply don’t believe the risk is worth the potential reward.

It’s entirely up to you whether you decide the same. It’s all down to your individual risk profile.

 

CFD Risk 3 – CFDs can move fast, potentially faster than you can react

Here’s a short animation of a CFD trade on gold ‘in flux’:

 

Snapshot of Gold Stock being traded.

 

As you can see, the gold price is constantly changing according to price action in the market.

If you monitor the price live, most of the time you’ll see it ‘ranging’. (This just means the price is constantly moving up and down within a specific ‘high’ and ‘low’.)

Here’s an example of Google stock in a ‘range’:

 

Dashboard of Class A Common Stock.

 

As you can see, it’s moving up and down in price within a fairly predictable pattern. When it hits the low point within the ‘range’, it rebounds back up, and vice versa.

The graph you can see represents just under 24 hours of trading.

Now, let’s add in the next 24 hours of trading:

 

Class A Common Stock showing a downward trend.

 

As you can see, the fall in price is sudden. In this case, it’s a fall in the price of about 5% in a day.

Now, 5% might not sound like a huge fall. But let’s say you’d used 40:1 leverage to obtain a £20,000 position in Google stock.

You would have only used £500 in capital to make the trade.

But your 5% loss here would have been £1000. Double your initial stake. In less than a day in this particular case.

If you’re going to trade CFDs using leverage, you need to be aware how fast the markets can move. Trading prices can move quick. Even quicker than this example in some cases.

And it’s also worth noting that prices don't just move quickly, they can also move in a non-linear fashion.

For instance, if the price of a share falls from 20.10 down to 20.00, it won’t necessarily move 20.10 to 20.09 to 20.08 and so on. It can easily leap straight from 20.10 to 20.00 in a second or so.

Again, that might not sound like much, but when you’re using leverage even a 10-point fall could mean a big loss.

Please understand that we’re not trying to scare you here.

The fast movement we’ve described here is also possible on the upside. You could gain 10 points – and make a substantial profit – just as fast as the loss examples we’ve given here.

But it’s very important to understand the risks of trading before you start opening positions for real, and the fact are that CFDs can move very quickly in price either direction.

 (That’s part of the reason markets.com have a demo account, so you can practise making, monitoring and closing CFD trades using demo funds. You don’t need to fund your account to use the demo account. So, if you are interested in becoming a trader and want to practise using the same ‘pro level’ platform our top traders use, sign up for an account today and download our CFD trading app.)

 

CFD Risk 4 – Margin means you’ll need more capital than just your stake

Margins aren’t necessarily a ‘risk’ as such, but you do need to be aware of them when trading CFDs.

So, we’ve included them here.

Here’s how margin works.

If you plan to use leverage, your broker will require you to add additional capital to your account above the cost of the trade itself.

Think of it as ‘collateral’, to prove to the broker that you aren’t making trades you can’t afford to make, and that you can cover yourself in the event of losses.

 

Here’s an example:

Let’s say you plan to trade 100 lots of silver, with each lot currently valued at £23.

The value of your trade is £2300.

Your leverage is 10: 1. This means you will need £230 in capital to place the trade.

For this trade, your broker decides that they want you to have 15% of the trade’s full value in your account as a ‘margin’.

15% of the trade’s full value - £2300 – is £345

So, you’ll need a total amount of at least £575 to place this trade. (Margin cost of £345 + trade capital of £230.)

 

(15% margin in a trade of this size would be quite excessive, but it is a good way to understand why you need more than just trading capital to get started, even with CFD trading.)

 

What happens if the price of my asset falls quickly, and moves below the ‘margin’ in my account?

Say your silver trade suffers serious, quick losses and the price falls by £400. Your losses are now bigger than the margin cost of £345.

This is what’s known as a ‘margin call’. (A phrase which lent its name to a 2011 movie starring Jeremy Irons and Zachary Quinto.)

If this happens, your broker will ask you to deposit more capital to ensure your margin returns to the level needed to ‘cover’ your trade.

 

BE WARNED. Your broker won’t wait until your account is in the negative before exacting a ‘margin call’.

 

See, there are actually two types of financial margin:

The example we just gave – the required margin to open a position – is known as the ‘initial’ margin.

However, all brokers will also ask you to keep what’s known as a ‘maintenance’ margin.

This is a specific percentage of the total value of your account’s open trades.

 

Example:

Let’s say that in your account, you have five open trades. Each of those trades is worth £10,000. A total value of £50,000.

If your broker sets a ‘maintenance margin’ of 25%, you will be required to keep at least £12,500 in additional capital in your account. (25% of £50,000 is £12,500).

This number will continually move depending on the value of your trades. If your total trades doubled in size to be worth £100,000, your required ‘maintenance margin’ would also double in size to £25,000.

The required maintenance margin percentage will vary from broker to broker, though in some countries it’s actually the financial regulator who sets the rate.

In the US, for instance, the Financial Industry Regulatory Authority (FINRA) has set the current margin at 25% of all securities.)

 

Can you trade CFDs without leverage?

 

buy hold cfd

 

Yes, it’s possible to trade CFDs without leverage, and some traders do exactly that.

In financial terms, using an un-leveraged CFD isn’t massively different to placing a traditional trade. (Though you may miss out on shareholder benefits, such as dividend payments.)

So, why do it?

Usually, the answer is convenience.

Imagine you want to place a short trade on the price of crude oil. The value of the trade is £10,000, and you have that in capital, ready to invest.

You can either choose to go the traditional short-selling route, which will involve borrowing and lending from a number of different parties, not to mention additional costs and fees…

Or you can place a simple unleveraged CFD with a couple of clicks on your trading platform.

If you plan on placing multiple short trades, then as you can see, CFDs can make things a lot quicker and easier.

It’s all a matter of what your trading goals are. If you’re only planning to place one short trade every year, then you might decide to go with the more traditional approach.

 

IMPORTANT NOTE. Not all CFD providers offer unleveraged trading. Be sure to check in advance if you plan on making it part of your strategy.

 

What are the costs of trading CFDs?

You’ll encounter a number of charges when trading CFDs. Not all of these will apply to every trade, but you should take the time to be aware of them all:

Withdrawal and deposit fees

Some brokers may take a small percentage of your capital as a fee when you’re making a deposit or when you’re withdrawing money. (markets.com does not do this.)

The spread

The ‘spread’ is the gap between the highest price a market will pay for any given asset, and the lowest price anyone holding the asset will sell at. This gap means that when you sell out of a position, the price displayed on your trading platform won’t be the exact price you sell for. The exact price will be somewhere in the ‘spread’.

Commission

Usually levied on share CFDs, commission means that the broker will take a small percentage of the full value of the trade as a payment. So, if you’ve taken a trade on Amazon stock worth £5,000, and the commission rate is 0.10%, your commission charge will be £5.  (markets.com does not currently charge commission fees.)

Overnight/rollover fees

These are small payments that are applied to your account if you hold a CFD trade overnight. These fees are pretty much universal within the CFD trading world. They can vary depending on if the trade is short or long, and on which asset you’re trading. Usually, a broker will list these fees on their website, so you can account for this kind of cost in advance.

Currency conversion fees

Different assets are valued in different currencies. So, if you trade crude oil in the UK, the trade will still be valued in US dollars. This means that your initial stake must be transferred from dollars to pounds, and then any profits must be traded back. This costs CFD brokers, who will then usually cover their exchange costs will a small additional charge on your trade.

Do you pay tax on CFDs?

Depending on your tax jurisdiction, you may be charged capital gains tax on any profits made from CFD trading. 

Start Trading Now

 

What are ‘lots’ in CFDs? (The difference between CFDs and spread-bets)

Trading CFDs, you don’t measure the size of your trade in ‘points’ like you with spread-betting.

When you trade CFDs, the size of your trade will be measured in ‘lots’. 

This is a unit of measurement that is unique to the asset you’re trading.

For instance:

  • For stocks, the ‘lot’ is the individual company’s share price
  • For gold, a ‘lot’ is typically a certain number of ounces. (100 troy ounces, say.)
  • For crude oil, a ‘lot’ is currently 100 barrels.

When you trade a CFD, your position size is measured in how many ‘lots’ you wish to trade.

 

Example:

So, let’s say you’re planning to trade gold, because you think the price is about to increase.

The current ‘lot’ for gold traders is 100 ounces, with a market value of £1800. (Each ounce is worth £18, so 100 ounces is valued at £1800.)

You decide to trade 4 lots, with a total trade value of £7,200.

By the time you close the position, the value of a lot has increased by £400 to £2200.

Your trade was worth 4 lots. So, your total profit on this trade is £1600. (£400 x 4.)

Here’s a second example based around shorting:

You want to short Tesla stock.

1 lot of ‘Tesla’ stock is a share, which is currently valued at £180.

You decide you want to trade a CFD for the value of 50 lots. The trade’s total value is £9,000.

The value of each lot falls to be worth £150, making your profit on each lot £30.

You traded a total of 50 lots, so your total profit is £1500. (£30 x 50.)

 

What if a ‘lot’ is too expensive for you to trade?

If your chosen asset is more expensive, a single lot may be too expensive for you to trade. (Or require more leverage than you’re comfortable with.)

In this case, you can choose to trade what’s known as a ‘micro-lot’. This means you trade less than the value of 1 lot.

So, in our Tesla example above, had you chosen to short at 0.5 per lot, the total value of your trade would have halved to £3,100, and your total profit would have been £800.

How small a fraction of a lot you can trade will depend on different factors, including:

  • Asset liquidity (the more liquid the asset, the smaller the available ‘micro-lots’)
  • The broker’s own internal rules

Typically, it won’t be possible to trade any lower than 0.1. of any asset.

 

Are CFDs legal?

CFDs are legal in many countries around the world. markets.com is a regulated broker in the UK, Europe, South Africa and the ASIC region.

As long as you trade through a regulated broker, CFD trading is legal.

 

Are CFDs safe?

As with all trading, CFDs carry risk. The more leverage you use, as we explained in our earlier example, the more you can lose. It’s possible to lose more than the actual capital you place the trade with.

As with all trading, if you’re not comfortable with risking your capital, you shouldn’t trade. CFD positions can move fast, and you should monitor all positions carefully.

 

So, here’s a summary of everything we’ve covered today:

  • A CFD is a ‘contract for difference’ between you and a broker to exchange the difference in an asset’s price when the contract opens, and when it closes.
  • There are 4 main benefits to trading CFDs - you can place short or long trades with ease, you can trade a wide range of assets, you can access more of the market and diversify with less initial capital.
  • When you trade CFDs, you don’t actually own the underlying asset – the CFD is simply derived from the asset’s price.
  • The risks of CFDs include loss of capital, multiplied loss due to leverage, fast-moving losses, additional capital required due to margin and risk of margin calls.
  • You can trade CFDs without using leverage, though this will depend on your broker.
  • There are 6 main potential costs of trading CFDs: commission, spread, withdrawal/deposit fees/overnight fees, currency conversion fees and capital gains tax.
  • CFD trades are measured in ‘lots’, which vary according to the asset you’re trading.
  • CFDs are legal as long as you trade through a registered broker in your region, and like all financial trades, CFD carry risk.

 

Where can I practise trading CFDs? Try the best CFD trading platform out there.

If you want to practise trading CFDs with no risk, then sign up for a markets.com account today, and download our CFD trading app.

We provide a full demo account, complete with artificial funds, so that you can get used to trading CFDs without losing any real money.

This gives you time to become a confident trader before you place any trades for real.

Then, if you do decide you want to step up to trading for real, you can fund your account properly, and get started.

You can click here if you’d like to open an account with us today.

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