What is CFD Trading?

Are you looking to stay on top of the latest trends in trading?

If there’s a new way to secure profits and manage risks through traditional markets, who wouldn’t want to hear about it? But the truth is, we know it’s also challenging to keep up with the new trading styles that emerge around stock, forex, and other markets.

So what about CFDs, you ask? Well, great question! 🙌

Maybe you’ve heard of CFD trading as a new way to trade without having to purchase actual assets, but you’re overwhelmed at the amount of information out there. Don’t worry—we’re here to explain CFD trading in depth, laying out everything you need to know in order to get started. 

As the world economy is expected to grow rapidly in 2021, we can expect traditional markets, and derivative markets like CFD, to grow with it. Get up to snuff on all things CFD trading, from the basics, to the costs—and how to get started.

Ready? Let’s get to it! 🚀

What is a CFD? 📜

CFD stands for Contract for Difference. In CFD trading, the buyer and seller enter an agreement that the buyer will pay the seller the difference between an asset’s current value and its value at the time of the agreement. 

With CFDs, you can speculate on price fluctuations and try to make a profit while managing the risks of losses without actually owning the underlying assets. In fact, the value of the asset doesn’t really factor into the equation—CFD trading is all about the difference in value at the beginning and end of the trade.

You might see CFDs referred to as a “derivative product.” This is because you are trading contracts that refer to assets, rather than the assets themselves. At the end of the day, it’s a speculative market that derives its value from other markets, like stocks and forex. 

While CFD trading is illegal in the US, investors outside of the US can generally take part in CFD trading through the same institutions where they make their trades. Many forex brokers and even the leading stock trading apps will allow you to make CFD trades.

Now, if you’re starting to get confused—stay with us! This is an advanced trading strategy, but that doesn’t mean you can’t get it down pat. It’s time to go into deeper detail on how exactly CFD trading works.

How CFD Trading Works 🏗

When you hear the word “speculator,” you might be picturing an old-timey gold miner. CFD trading is speculation for the 21st century—so hand that (non-American) miner a smart phone with a good trading platform, and he or she should be good to go!

Just kidding. Of course, CFD trading requires some skill in analyzing stocks, and just like with forex trading, you’ll want to stay on top of global events. For example, knowing that key financial advisors are claiming that Britain has too much debt for higher interest rates and that British stocks might outperform most markets in the near future might affect your speculations on the GBP.

But for now, let’s try to get down to the basics that even our old-timey speculator can understand. That speculator is making a trade on whether a certain patch of land has gold on it. Today, CFD trading allows you to place orders on whether a given asset will rise or fall.

Now, the gold speculator can only secure profits and manage risks if he speculates that there is gold—he can’t speculate against a certain patch of land having gold on it, he can only opt not to buy it and walk away. But in CFD trading, you can speculate that the asset will move either up or down.

If you speculate that it will increase, then you will try to sell your holding after the asset’s price increases. If you speculate that it will decrease, you can place an opening sell position, and close the position by buying an offsetting trade.

CFD Trade Example 💱

Let’s go through an example of a profitable CFD trade and an unprofitable CFD trade. We can set them up the exact same way. First, let’s say you are following a company called “XYZ” that is trading at 97 / 100. This means that 97 cents is the sell price, and 100 cents is the buy price, with a spread of 3.

If you think that the value will increase, you open a long position (speculating that it will go up) by buying 10,000 CFDs (“units”) at 100 cents. You would likely have to pay a commission to your broker, which is often 0.1% of the total trade size. In this case, 10,000 units multiplied by 100 cents = $10,000 for the total trade size. Then, $10,000 x 0.01% commission = $10 for the commission fee. 

Next, you’ll need to know the company’s margin rate. The “margin” refers to the amount you’ll have to deposit of the trade’s total value in order to secure your position. Let’s say that company XYZ has a 2% margin rate. 

This means that you’ll have to deposit 2% of the trade’s total value: in this case, $10,000 x .02% = $200. Margins can be tricky: if the price moves against your speculation, you may lose more than this margin, as your losses will be based on the position’s total value. 

Outcome 1: Profitable Trade 📈

Now that we’ve set up this story, let’s finish it out in two ways. If this were a choose your own adventure, the choice would be pretty clear: you’d want a profitable trade! So that’s what we’ll go through first. 

Let’s say the price rises to 112 / 115. You close your trade by selling for 112 cents. You will have to pay another commission when you exit a trade, so that would account for $11.20 at closing time (10,000 units x 112 cents = $11,200 x 0.1% = $11.20).

To calculate your profit, first see how the price moved in your favor. In this example, it moved from your buy price of 100 cents to your sell price of 112 cents, a 12 cent profit per share. Multiply this by the 10,000 (the number of units you bought in this example), and you’ll see that your profit is $1,200. Then, subtract the commission charges (which total $21.20) for your final profit of $1,178.80. 

Not bad, right? Now let’s look at a losing trade using the same premise.

Outcome 2: Unprofitable Trade 📉

Nobody likes to think they’ll lose a trade, but we all know it’s possible. Instead of the price of company XYZmoving up, let’s say it moves down to 90 / 92. You decide to sell at this point before the asset takes a major plunge, so you’ll be selling at 90 cents. This would result in a $9 commission when you close the trade. 

The price has decreased 10 cents, from 100 cents to 90 cents. You can calculate your loss by multiplying this difference by the number of units (10,000) – in this case, your loss is $1,000. Then, add the total commission charges ($19) for your total loss of $1,019.

Not as fun of an example—but hey, at least now you’re prepared for when stock markets dip, like European markets did after the third wave of COVID fears. You can always do these calculations to help you determine whether you need to sell to mitigate your losses, or hold out to see if the asset turns back in your favor. 

The Costs of CFD Trading 💸

There are some basic costs that will come into your CFD trading. These will vary by broker, and price is certainly a factor in what makes a great CFD trading platform. Here are the basic terms you need to know.

Buy Price, Sell Price, and Spreads 🔎

As mentioned in our above example, CFDs are quoted as two prices: the buy price and the sell price. For example, 99 / 101 would represent a buy price of 99 and a sell price of 101. You can open a short CFD for the sell price, and a long CFD for the buy price. Buy prices are always just a little higher than the market price, and sell prices are always just a little lower. 

The difference between the buy and sell price is called the spread. In 99 / 101, the spread is 2. When you trade CFDs, you have to pay the spread: you enter the trade with the buy price and exit with the sell price. The smaller the spread, the sooner you make a profit as the asset’s price fluctuates. 

If you’re used to understanding commissions and spreads in forex, note that this is a different application of the term. 

Overnight Costs (or Holding Costs) 🌜

You definitely want to be aware of whether your broker charges overnight costs. These are fees charged if you hold your positions overnight, or through the end of the trading day. Overnight costs are one of the major reasons why people lose money trading CFDs, so make sure that you are aware of your fees and factoring them into your potential profits. 

So how do platforms justify overnight costs? On long positions, they basically see that as an investment. And since you borrowed money from them for your “investment,” they’re going to charge you interest. That interest accrues each day the position is open, and that’s what makes up your overnight cost. 

Commission Fees 💰

Many brokers charge a commission on any trades. As we reviewed in our earlier example, commissions are often charged upon both entering and exiting a trade. Make sure to review your platform’s commission policy and frequency. 

Is CFD Trading Worth it? 🔦

CFDs are notorious trading instruments because a great majority of traders lose money on them. However, they are the easiest way to trade international stocks in many countries. 

Some traders without access to international brokers may still want to invest in popular US stocks, and CFDs are a way they can do that indirectly. As Biden’s stimulus is set to return the global economy to its pre-COVID path, many individuals may want to use derivative strategies to access otherwise inaccessible global markets.  

Let’s break down the advantages and disadvantages of CFD trading so you can decide if it’s the right path for you. 

The Good, the Bad, and the Ugly with CFDs

So at this point, we have a brief overview of the good and the bad with CFDs. But let’s jump into these in further detail.

Advantages of CFD Trading ✅

CFD trading offers higher leverage than traditional trading, with many trades requiring just 2-3% margins. This can magnify your wins—but of course, it can also magnify your losses. 

CFD trading allows you to access global markets around the clock. There are no prohibitions against shorting, and brokers offer many of the same professional services as with other types of trading but without the fees and without day trading requirements. Using CFDs also allows you to trade across stock, index, currency, commodity, and even more markets, allowing you to pursue a diverse portfolio. 

However, perhaps the only advantage CFDs have over stock trading is liquidity—since you have a contract, you don’t have to find a buyer or seller when it is time to close your position. A stock trader might struggle to get someone to buy their assets quickly while a CFD trader is secured with a contract.

Drawbacks of CFD Trading ⚠️

CFD trading also comes with its drawbacks. Traders pay the spread on CFD trades, which makes it harder to profit from minor fluctuations and decreases winning trades by a small amount. This may balance out the lack of traditional fees for services.

CFD trading is also not highly regulated, so brokers are evaluated based on reputation rather than government standing. Trading higher leverage also means greater risks, so CFD trades must be watched carefully. 

Also, maybe the less-obvious problem of CFDs is their psychological influence. Since trading like this requires you to click one of two buttons (up or down) it can be very alluring to make a rash decision. The simplicity of CFDs draws investors to make quick, unwise decisions on the spot, which is one of the reasons why CFD traders lose a lot of money compared to day traders.

Is CFD Trading Legal? 👨‍⚖️

CFD trading surged in 2020, likely due to volatile markets through the COVID-19 pandemic and the ability to make money through CFD off of market downturns. However, they are not legal in all countries, and regulations vary. 

CFDs are not allowed in the United States. They are also banned in Brazil and Hong Kong. They are allowed but tightly regulated in Australia, where the Australian Securities and Investment Commission (ASIC) is reducing available leverage. 

CFDs are allowed in several over-the-counter markets in countries including the United Kingdom, France, Germany, Canada, New Zealand, Sweden, Italy, Thailand, Denmark, Switzerland, and others. 

How to Start Trading CFDs 🏁

So, you’ve made it this far, and now you’re ready to start trading CFDs! Here’s a step-by-step guide to get you started making great trades.

Step 1: Learn Your Market 📚

If you want to trade stocks using CFDs, you’re going to need to know the stock market. If you want to trade forex using CFDs, you’re going to need to know the forex market. You get the idea. 

Learn how to research stocks to determine whether you should bet for or against a certain stock. If you want to bet on the changes in the currency markets, learning about forex is possible through free online resources or your broker.

You’ll also want to keep up with world’s political and economic news. If you’re trading global currencies, you’ll want to understand key issues like Australia’s reliance on iron ore or the UK’s unexpected drop in unemployment. 

In the stock market, you’ll want to stay on top of things like the recovery of GameStop stock after its post-”meme stock” losses. High-stakes, unpredictable stocks like these are not something you should focus on as a CFD trader, despite the potential profits.

Step 2: Prepare Your Capital & Find a Broker 🕵️‍♂️

In order to start trading CFDs, you’ll need some capital to secure your positions. Once you’ve saved enough to get started, you’ll need to open an account with a reputable trading broker like eToro. Because CFD trading is unregulated, there are a lot of scams out there—be sure to go with a reputable site that can help you make the trades you want without exorbitant commissions or fees.

Here are a few CFD platforms trusted by traders across the globe:

Step 3: Pick a Strategy & Stay Cool 💎🙌

Finally, pick a strategy that works for you (described below). You’ll need to dedicate time to your CFD trading and make sure that you are aware of how your positions are faring throughout the day. If your broker offers overnight holds, be sure you have a dedicated time each day to close the positions you need to close. 

Most importantly, keep a consistent schedule and a cool head. Don’t get discouraged if you end up with big losses one month. Many traders try to make up for a month’s worth of losses in a big, emotional charge at the markets. This never works! 

Don’t throw good money after bad. Make logical trading decisions based on your strategy, and find a calm time to revisit your strategy if it is consistently not working. Not every trade will be successful, so prepare to cope with some amount of loss.

How to Trade CFDs Effectively 💡

There are a few common approaches to trading CFD that can help you make sound decisions. Following are three popular strategies that may work for you. 

News Trading 📰

Many CFD traders open and close positions within a single day—called scalping or day trading. This keeps you from having to pay overnight fees, but you will have to follow the markets very closely. 

Scalping takes advantage of tiny market fluctuations, opening and closing positions within minutes. You can apply many of our forex scalping strategies to CFD trading as well. Set up one-minute, five-minute, and ten-minute calendars to make fast decisions on your positions. 

Some news traders will invest just before a statistics’ release, meaning you try to anticipate traders’ reactions to the release. This can be high risk, as it’s hard to know how news will impact traders. Others will invest according to the regular fluctuations of the market. 

Pair Trading 👟👟

Pair trading is most commonly used with CFDs on stocks, though they can also be used in other markets. It can be used in highly volatile or more quiet periods in the market.

Once you’ve chosen your industry, invest in two CFDs that correlate in the same industry with one long and one short position. These assets should be highly correlated but on their way to being less correlated. Thus, changes in the pair’s correlation will allow you to secure profits and manage risks. 

You will win with one position and lose with the other position. You will make money on the relative changes of the two stocks in the pair, not in the overall market direction. 

Hedging ⚖️

Hedging can be used as a risk management strategy, as it reduces or negates risk from your other investments. Essentially, you open a short position on an asset that you have invested in, which allows you to hedge against short-term decreases in value without giving up your assets.

This is a more complicated strategy but the extra complexity pays off in the long run. Expert CFD traders use hedging when they are not too certain that their price predictions will come true—consider hedging if you’re interested in risky assets.

What You Need to Know to Trade CFDs 🎓

Now, you’re basically an expert on CFD trading. We’ll just go over a few key concepts to make sure you can speak the lingo as well as anyone!

Long and Short CFD Trading 📐

A “long position” refers to speculating (through your CFD) that an asset’s price will increase. A “short position” refers to speculating against an asset’s price, so you gain a profit as the underlying asset decreases in price. For both trades, your profit or loss is determined when you close the position. 

CFD Margin and Leverage ⚙️

CFD trading is leveraged, meaning you are able to control a large amount of capital with a small up-front deposit. Your deposit is referred to as the “margin.” 

Many traders or brokers will have a minimum “margin rate” such as 2%, meaning your margin will need to equate to 2% of the value of the overall trade. You’ll also have a leverage ratio, such as 20:1, which refers to how much capital you control for every dollar of margin you put down. 

Leverage allows you to stretch your capital to larger positions, potentially magnifying your gains. However, it can also magnify your losses. It is possible to lose more than your margin if your position drops substantially.

CFD Lots 🎛

CFDs are traded in “lots,” which refers to the size of your trade. Different markets will define the value of the lot differently. 

Duration of a CFD 📆

Most CFD trades do not expire after a certain duration as options do. This lack of expiration is one of several differences between CFDs and options.

You close a position by placing a trade in the opposite direction of your opening trade. However, you can get charged overnight fees if you hold a position past the cut-off time offered by your broker. 

How are CFDs Taxed? 🏛

CFDs are subject to capital gains tax, just like stocks or forex. Your specific capital gains tax will depend on what country you’re trading from. Some countries do not tax CFD trading, while others tax it the same as other gains. 

Capital gains tax in the United Kingdom is 18%, though you don’t have to pay stamp duty. In South Africa, capital gains are added to the rest of your income to determine your overall income bracket. In Canada, 50% of the value of your gains must be added to your taxable income. Look up your country’s tax rate to determine what to expect before you count your profits.

Note: The information on the page is not to be considered as tax advice in its legal form, rather having informative purpose.

Conclusion

CFD trading requires some skill, so make sure you understand what you’re getting into before you get started. These derivative products give you access to any market in the world, and you’re essentially making speculations for or against particular stocks, currencies, indices, and more, without owning the underlying assets. You’ll get professional services for smaller fees and be able to wield a high amount of leverage, but you may also deal with unregulated brokers and risk more as you control larger amounts of capital.

With dedication and knowledge, you may decide that CFD trading is right for you. Make a consistent strategy and plan for your trades, and stay up to date on market fluctuations and world news, such as tech companies flocking to London. Decide whether you want to trade using a news strategy, pair strategy, or hedging. Keep at it, and hopefully you’ll see your portfolio increase!