What is CFD Trading?
CFD Trading is the buying and selling of “Contracts For Difference” – referred to as “CFDs”. It is a growing form of investment. They allow traders to speculate on price movements of an asset. Often offered with leverage, they give traders the ability to speculate on stocks, forex, commodities or indices.
In this article, we will:
- Define a CFD and explain what it is.
- Show an example of a trade, with a short tutorial.
- Show advantages and disadvantages of this form of trading.
- Explain how to find the best broker account or software for you.
- Offer some “Beginners Tips” to help analysis
Contracts For Difference Defined
A Contract For Difference (or CFD) is a contract between a broker and an individual trader. It is a form of derivative. The difference refers to the value of the underlying asset at the time the contract is agreed (the strike price) and the value after the trade ends. It is essentially an agreement to exchange the difference in these two values.
The underlying asset is not brought and sold, but the contract allows traders to speculate on price movements of that asset
What is a CFD?
So a CFD is a derivative product. The trader does not own the underlying asset at any stage. Brokers create CFDs in a wide range of individual equities, indices, commodities and forex. The price is determined by the markets. The length of the contract will vary. Trades may last just a few seconds, up to months or years.
CFDs are generally used for shorter time periods (days or weeks) as more traditional investments are seen to offer better value over longer periods.
The contract features a ‘buy’ and a ‘sell’ price (known as the ‘spread’), with an ability for traders to go long (buy) if they believe market prices will rise, or go short (sell) if they believe market prices will fall.
If the market moves in line with the trade, profits from the contract will rise in line with that movement. Conversely if the market moves against the trade, losses increase. These contracts are often offered with a degree of leverage. This increases potential profits – but also potential losses – and therefore carries much greater risk.
An Example Of A CFD Trade
Here is a ‘walk through’ of a Contracts For Difference trade.
In our example, we are going to open a trade on Vodafone. The specific screens and layout will differ between brokers, but the fundamental elements will remain:
- Notice the ‘Sell’ and ‘Buy’ values differ. The gap between values is known as the “spread”. This small percentage is how the broker will derive a profit.
- In the example we have selected ‘Buy’, and set the trade size to £1. This means for each whole unit the asset price moves, our position will go up by £1 or down by £1.
- We have also entered a figure in the ‘Stop loss’ box. This is a risk management tool. In the example, our stop loss is set 5 points away from the opening price. This should limit our potential loss to just £5. Stop losses however, are not always guaranteed.
- The ‘margin required’ (highlighted in red) is the amount of funds needed in the account in order to open the position.
- Lastly, click the ‘Place Deal’ button to confirm the trade. We now have an ‘open position’ on Vodafone, for £1 per point.
In a similar way to the trading screens, brokers will display open positions in a variety of styles – but always show the same details:
The opening price shows our ‘strike’ price, and the latest price is just that – the current market value. Our stop loss value is shown – as is the current profit/loss. As our trade has only just been opened, we have to ‘make up the spread’. So the position is currently 50p down.
As the spread needs to be covered, almost every trade will open at a small loss – just as it has above.
When we decide to end the trade, we simply click the ‘Close’ button. Alternatively, we can open a new trade, and ‘Sell’ Vodafone for £1 per point. But using the ‘Close’ button is far easier.
There is no time limit or expiry on a cfd.
Our £1 cfd effectively exposed us to £200.85 worth of investment. This is important to remember. While the broker only requires you have £7.55 in the trading account, you are still exposed to risk beyond that. If the Vodafone share price collapsed for any reason, the trade could lose way more than £7 or £8. Losses can exceed deposits. For this reason the stop loss is a vital tool in risk management.
Trading Example – Result
After opening the trade above, we now have an open position – What happens now?
Our trade will now mirror the fortunes of the Vodafone share price. For each penny the stock price rises or falls, our positions will gain, or lose, one pound respectively. So here are some scenarios:
The share price rises.
Assume the spread on Vodafone shares reaches 205.85-206.35. In order to close our ‘Buy’ position opened above, we need to ‘Sell’ the same value of assets. So we will be taking the lower side of the spread – in this case 205.85.
Our original ‘strike’ price was 200.85. If we close the trade at 205.85, the cfd has closed 5 points higher. This means we are due 5 times our trade size – in our example £1 – so:
5 x £1 = £5.
The share price falls.
Assume the spread has dropped to 195.85-196.35. We still need to ‘Sell’ (and take the lower side of the spread). So the trade now settles at 195.85. The value has dropped 5 points, meaning we lose 5 times our trade size:
5 x -£1 = -£5.
Notice our stop loss was set at 195.85 above. This means our position would automatically close if the spread reaches that point. This is why the stop loss setting shows -£5 in red. That is the amount the trade will lose if the stop loss is triggered. If the price continues to go down, your trade will not lose any further funds. The caveat to this is that in extreme market conditions, stop losses may not be guaranteed, and may slip.
Remember, the point at which you close the deal is down to you.
In our example above, we opened a trade which gave us access to a trade value of £200.85 – equivalent to buying 100 Vodafone shares. The same process can be used to trade Gold, the price of oil or foreign currency.
Our example used a very small trade size, but factoring it up is a simple process. You can see then, how leverage can give cfd traders a large portfolio of investments, for a fraction of the outlay of traditional investments. With leverage comes risk however. Traders should note how much leverage and risk they are exposed to, and manage it correctly.
Trading CFDs – Key Points:
- A CFD is a linearly leveraged financial product. Profits and losses increase in direct relationship to market performance. The leveraged nature of CFDs mean, therefore, that your losses can exceed your initial investment.
- A CFD does not have a fixed maturity date. The trader will dictate when the contract expires. When you judge that it’s the right time for you to close a position, this is done by placing a trade of the same value in the opposite direction. Most brokers will however, make a very small charge for positions held overnight. Each charge is miniscule relative to the trade size – but is repeated each night.
How and why CFD trading can be useful
Take a position in a falling or rising market
With the choice to go short or long, you have the potential to generate profits regardless of which way the market is trending.
Hedge your wider investment portfolio
Where you are invested in physical shares, your hope and expectation is obviously that they will increase in value. You may also expect to collect a dividend. But where there is a very real risk of those shares leaking value, CFDs can play a useful hedging role.
So if you hold stocks in a certain company, short selling CFDs based on the same shares can be a useful way of making a profit from any short-term downtrend. In turn, this can partially or wholly offset any loss from the portfolio. This security measure can be an especially useful strategy to adopt in volatile markets.
While share dealing attracts stamp duty liability, the same does not apply to a CFD trade. Depending on your circumstances, any losses incurred may also be used to offset against your capital gains tax (CGT) liabilities.
Risks associated with CFDs
Leverage and margins
To open a CFD position, it is necessary to deposit an amount in your brokerage account, known as a margin. This ‘position margin’ tends to depend on the size of your position and the type of underlying asset. The good thing about this is the ability to deposit a percentage of the full value of the position, which means your money linked to the position is not tied up in one transaction and can be used for other investments.
The downside is that it is possible not just to lose your initial deposit but also be required to make further payments.
CFD Trading – leverage risk
Keeping track of transactions
Failure to ensure you have enough funds in your account to cover total margin requirements could mean that some or all of your positions are closed out. Managing multiple CFD trades requires you to constantly monitor your account, depositing additional funds where necessary.
Use reputable, regulated brokers
In the UK, there are a great choice of reputable brokers. Fully regulated by the FCA. Traders can use these firms with confidence. This form of trading is not as strictly regulated as other forms of investment however, so you need to be selective when deciding on a broker. We offer more advice on finding the right broker below.
Is CFD trading for you?
CFDs offer a dynamic and sophisticated way of trading – although the possibility of losing more than your initial stake mean that it isn’t for everyone.
When looking for a platform, it’s important to opt for a format that you are comfortable with; one that allows you to keep control of your trades and one with a competitive spread – i.e. a narrow difference between buy and sell prices.