CFD Trading: Overview, How it Works, and How to Trade Them

Trading CFDs is one of the ways to participate in the capital markets by investing in different asset types. Here, we take an in-depth look into CFDs, how CFD trading work, and how you can trade them.  

Contracts For Differences (CFDs): An Overview

A Contracts for Difference (CFD) is a legal agreement between two parties to trade based on the difference between the opening and closing prices of specific financial instruments.^[1]

In simple terms, if the closing price of a CFD contract is higher than its opening price, the seller pays the buyer the difference, and the buyer makes a profit. The inverse is also true. If the closing price of a CFD is lower than its opening price, the buyer pays the difference into the seller’s account with a loss.

This nature of CFDs makes them unique vehicles for trading both bull and bear markets. Since prices fluctuate wildly during both market cycles, you can use CFDs to take advantage of price differences in underlying markets and potentially create market opportunities from your predictions.

Since CFD markets have high liquidity, they can be considered as instruments for short-term traders looking to get into and out of different trade positions fast within a given timeframe.

Also, CFDs trade over the counter through brokers and market makers. The two-party nature of CFDs makes it impossible to trade on major exchanges and you can only trade CFDs with one counterparty, your broker.

CFDs allow you to trade many assets and securities. Here are some common examples:

• Commodity CFDs — With commodity CFDs, you can speculate on the price of different commodities, including gold, silver, coffee, oil, and natural gas.
• Forex CFDs — CFDs are an alternative way to gain exposure to foreign exchange markets without owning any currency pairs.
• Futures CFDs — Futures and CFDs have some commonalities, including liquidity. However, futures CFDs allow you to gain market access to price changes in futures. contracts without owning the futures contracts or assets underlying these futures.
• Share/Equity CFDs — These CFDs mimic the price movements of actual shares and equities across global markets
• Index CFDs — If you prefer to trade the entire stock market at once, you can use index CFDs to get exposure to indices without owning an actual index.

Features of CFDs

Here are some standard features across all CFDs:

1. CFDs Are Derivatives

In the context of CFDs, derivatives allow you to speculate on the price movements of actual assets rather than purchase them. As we’ll discuss shortly, the derivative nature of CFDs is a significant perk. You can create trading opportunities from an underlying asset without owning it.

2. CFDs Are Leveraged

Leverage is a feature that allows you to trade CFDs without paying the total cost of your position upfront. Your broker enables you to trade on margin – the minimum capital required to open a CFD position.

3. CFDs Trade Over the Counter (OTC)

CFDs trades are executed between only you and your broker. There are no third parties involved. For this reason, you won’t find CFDs on any exchange. CFD contracts, by nature, support only two participants: the buyer and the seller.

Advantages of Trading CFDs

What are the advantages of CFD trading? Let’s take a closer look at what it is and some of its benefits. 

1. Potential for upside in both bull and bear markets — Because CFDs capitalize on price differences, you have the opportunity for an upside from both bear and bull markets. You also enjoy flexibility with CFDs, and you can enter the financial markets at any time you please.
2. No expiration date — There is no set time limit for you to trade CFDs. You can get into a long-term CFD position and wait for it to mature before selling it. Also, the value of CFDs does not depreciate over time.
3. Lower trading costs — Compared with other trading instruments, CFDs charge lower fees. Typically, you’ll pay brokerage fees, commissions, spread, and additional minor fees to keep your CFD positions open during a trading window.
4. CFDs are excellent tools for hedging — You can use CFDs to hedge other positions in your trading portfolio. Because CFDs require limited capital to open a position, you can open a position and create trading opportunities even with a small amount of money. This is a useful trading strategy when you’ve taken a risky position on a CFD or when a long-term position is accruing losses. 
5. Extend your trading with leverage — CFDs allow you to trade with a capital size larger than your actual deposit. You can control more significant positions by using leverage and the minimum capital required. 
6. Wide range of markets — CFDs allow you to access thousands of capital markets worldwide without accessing multiple platforms. You can even trade emerging markets like cryptocurrencies using CFDs. Besides that, you can also trade specific markets outside regular trading hours. 
7. Underlying asset ownership — You can trade CFDs without owning the underlying asset. You only put up capital to trade the underlying asset’s price movements.

Now that we’ve studied the advantages of CFD trading, you also need to understand its potential risks and pitfalls. Before CFD trade on any CFD trading platform, here are some of its disadvantages: 

Disadvantages of Trading CFDs

1. Leverage is a double-edged sword — Although you can create trading opportunities by leveraging your positions, you risk incurring losses that exceed your capital when you don’t use leverage wisely. Using excess leverage can wipe out your CFD trading account and leave you in debt with your CFD providers.
2. Overtrading — CFDs offer a cost-efficient way to trade the markets. Because you can meet the lower margin requirement most brokers provide, you may fall into the trap of overtrading. Overtrading exposes your portfolio to the markets more than you can stomach, and your remaining capital may fail to cover any losses you incur.
3. Costs grow over time — Trading CFDs over short time spans can be cost-efficient. However, your costs can pile up. An example of such a cost is the overnight funding fee. Over several weeks of a long position, your overnight fees may negatively accrue and impact your returns. 
4. Inflexible leverage levels — The CFD provider sets the level of margin and leverage required for each market. You have no option but to accept these terms and develop risk management strategies around them. These terms could change at any time, and you’ll have to meet them, or your broker may stop you out of your current positions.

How CFDs Work

Let’s define some standard terms you’ll encounter while trading CFDs.

Margin

Margin is the minimum capital required to open a CFD position with your CFD broker. Your broker allows you to borrow funds against your margin to increase your market exposure. This facility, also known as leverage, can potentially magnify your returns if used correctly^[2].

Your broker holds your margin as collateral to keep your positions open during your trading cycles. You may need to deposit more funds into your brokerage account to open more CFD positions.

Each broker has different margin requirements, depending on your jurisdiction and internal policies. Also, different trading instruments and financial assets could have different margin rates, depending on the liquidity and volatility of the underlying assets.

Leverage

Leverage increases your exposure to an underlying market. Essentially, leverage is a loan your broker gives you to cover the full value once you make the minimum deposit needed in your account^[3]

Most brokers present leverage as a ratio, such as up to 500:1.

Here’s a quick example of how this works, for illustration purposes only:

Let’s say your broker has a 1% margin requirement for you to trade 1,000 CFDs of Company A with a share price of $200.

Without any leverage, you’d have to pay the total cost of the trade and purchase 1,000 shares – a total of $200,000 to open this position.

With leverage, you’d only need 1% or $2,000, to open the same position with your broker.

So, if the share price of Company A goes up by 10%, you make the same profit as the entire trade, but at a considerably reduced cost.

Putting up a 1% margin for this trade means you have a leverage ratio of 100:1. Some brokers offer leverage as high as 500:1, while others offer lower.

The Relationship Between Leverage and Margin

Margin and leverage go hand in hand with all CFD trades. You need margin to trade using leverage, and leverage uses margin to give you the power to control more significant positions with limited capital.

Long Trades vs. Short Trades

Since CFDs take advantage of price changes in the underlying markets, you have the opportunity to create trading opportunities from both long trades and short trades.

Long Trades

When you take a long position in a trade, you have purchased an asset to sell later when the price goes up. “Going long” and “buying” are the interchangeable terms most day traders use to take such a position^[4].

Some trading platforms have also adopted these terms. Some have “buy” on their trade entry buttons while others have “long”.

Short Trades

Taking a short position can be quite confusing to new traders. Unlike long security positions where you buy an actual asset, short trades sell assets before buying them in the hope prices fall so you can sell to another trader^[5].

“Sell” and Short” are two common ways to describe a selling position. Trading platforms also use both terms interchangeably.

Hedging

Trading CFDs is a common risk management strategy for mitigating any losses in your existing trading portfolio^[6].

CFDs are useful as a hedging tool as you only need margin and leverage to replicate a short position to hedge against loss from a long position.

Fees

Trading CFDs incurs some costs. They include:

Spread

All CFDs come with two quotes: The sell (bid) and buy (offer) prices. The bid price is the price at which you can short a CFD trading contracts.. On the other hand, the offer price is what it costs to open a long CFD position.

The bid price is usually slightly lower than the market price of the underlying asset and the offer price is slightly higher.

The spread is the difference between these two prices^[7].

Commissions

In most cases, the spread covers the cost of the trade. The only exception is stock/share CFDs where the sell and buy prices match the underlying market. Instead, you pay commissions to trade them. Commission rates vary across brokers but in most cases an average of about 0.1%.

That makes the experience of trading share CFDs as close as possible to actual share trading.

Financing Costs

If you’d like to keep your position open overnight, you’ll pay your broker an overnight financing cost to keep your position open. Overnight positions are considered investments, and your broker will charge you interest for every night your position remains open.

Charges for Extra Services or Facilities

Some brokers offer services like guaranteed stops charged at small premiums. That way, your broker guarantees you protection for all your positions against slippage and sudden losses. You may pay other fees for services like:

• Direct market access for share CFDs
• Inactivity fees
• Currency conversion fees

How to Trade CFDs

To trade CFDs, you can follow these steps:

1. Open a Trading Account With a Broker of Your Choice

First, open a trading account with a broker of your choice. You can follow the procedure found on their website and you’ll be up and running in a few minutes.

Most brokers ask for your identification documents and proof of address to verify your account. Once verified, you can access all the full features of your trading account.

2. Fund Your Trading Account

There are multiple ways you can fund your account, depending on the funding options offered by your broker. You can even fund in currencies that are not your local currency, if you prefer. For example, one way is to connect your credit/debit card directly to your trading account to fund the account.

If you’re still unsure, you can open a demo account in a risk-free environment that lets you trade without loss.

3. Create a Trading Plan

A strategy is the backbone of successful trading activities. A trading plan helps you determine:

• Your trading window
• Your risk appetite
• Capital for opening leveraged positions
• Markets to trade

A trading plan helps you make calculated decisions that protect you from wiping out your account. With a plan, you make better decisions on your desired returns, acceptable loss, and risk mitigation strategies that protect your capital.

4, Choose a CFD Market to Trade

CFD markets are wide, and some brokers offer thousands of markets to choose from. You can opt for:

• Commodities
• Cryptocurrencies
• Stock indices 
• Shares

Choose a market you’re familiar with, or have sufficient knowledge about. That will be able to help you make better trading decisions.

5. Open and Monitor Your First Position

Once you’ve chosen your markets, decide whether you want to go long or short. CFDs give you the opportunities to access both options.

There are several ways to monitor your position. You broker can:

• Send you SMS messages
• Email alerts
• Push notifications

You can also monitor your positions directly from your trading platform.

6. Close Your First Position

Once your position moves in your favour, you can use the “close” button to exit the trade. You can also use this button to exit any losing trades and take an acceptable loss. To close a long position sells your CFD and closing a short position buys a CFD.  

Your broker will deduct their fees from your return on investment or your capital if you incurred a loss.

Final Thoughts

CFDs have become the go-to choice for many traders, particularly for the modern CFD trader who aims to hedge their portfolio position or requires access to limited capital. Engaging in CFD trading allows you to benefit from leveraged trading in volatile markets, minimal fees, and a broad range of asset classes, including forex pairs. 

To navigate the buy and sell price fluctuations, you can go long or short depending on your strategy, and practice CFD trading across thousands of markets. However, be cautious of market risk and the potential pitfalls of leverage. If misused, leverage can lead to losses that exceed your initial capital. Therefore, it’s essential to have a thorough understanding of the market and develop a sound trading strategy to mitigate risks and maximize returns. 

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References

1. Contract for Difference (CFD). (2022). Retrieved 13 April 2022. https://corporatefinanceinstitute.com/resources/knowledge/finance/contract-for-difference-cfd/ . Accessed on 6 July 2022
2.  Margin Trading: What It Is And What To Know – NerdWallet. NerdWallet. (2022). Retrieved 13 April 2022, https://www.nerdwallet.com/article/investing/what-is-a-margin-trading-account-and-how-does-it-work . Accessed on 6 July 2022
3. Trading Stocks With Leverage. The Balance. (2022). Retrieved 13 April 2022, https://www.thebalance.com/trading-using-leverage-1031047 . Accessed on 6 July 2022
4.  What Is a Long Position?. (2022). Retrieved 13 April 2022, https://www.investopedia.com/terms/l/long.asp . Accessed on 6 July 2022
5. Short Selling. (2022). Retrieved 13 April 2022, https://www.investopedia.com/terms/s/shortselling.asp . Accessed on 6 July 2022
6. “A Beginner’s Guide To Hedging”. Investopedia, 2022, https://www.investopedia.com/trading/hedging-beginners-guide/ . Accessed on 6 July 2022
7. Spread Definition. (2022). Retrieved 13 April 2022 . https://www.investopedia.com/terms/s/spread.asp . Accessed on 6 July 2022