What are CFDs?
CFDs, or Contract for Differences, are financial instruments that allow traders to speculate on the price movements of various assets without owning the underlying asset itself.
When trading CFDs, traders enter into an agreement with a CFD broker to exchange the difference in price of an asset from the time the contract is opened to when it is closed. This means that traders can profit from both rising and falling markets, as they can take either a long (buy) or short (sell) position.
My key takeaways
- CFD trading uses the difference between two specific price points to calculate the returns or loss of a position.
- CFDs use leverage and are a particularly advanced way to trade.
- You never own the underlying asset when trading CFDs.
How do CFDs work?
CFDs are a method of trading financial markets such as stocks, stock indices, forex, and currency pairs.
It works by partnering CFD traders who want to speculate on the price movement of an asset with a broker, who provides the contract.
A contract is then opened, binding the trader and broker to either buy or sell a predetermined number of units of an asset once it reaches a certain price point.
Using the price at which the contract was opened between the CFD trader and broker – this is based on the price of the underlying asset – their returns or losses depend on the difference between the opening price of the trade and the price at which it is closed.
Essentially, CFDs are tradable contracts between a client and the broker, who are exchanging the difference in the initial price of the trade and its value when the trade is closed.
As such, when you open a “buy” trade, you speculate that the price of an asset will rise. Your returns or losses are correlated to the difference in price between the opening and closing values of the asset – the asset’s price must increase for the buy position to profit.
Inversely, sell positions involve speculating that an asset’s price will decrease. Losses are still determined by the difference in opening and closing prices, only the price must decrease for you to profit from sell positions.
How much you gain or lose is determined by multiplying your total position size by the difference in price between when you opened and closed the contract.
You never own any of the underlying assets that you trade – you enter a hypothetical agreement to either buy or sell an asset at the price you agreed in the contract with your broker. This is unlike traditional trading and investing, in which you purchase and own assets, such as stocks and shares or fund units.
One of the key features of CFDs is the leverage they offer. Traders are only required to deposit a fraction of the total value of the position, known as the margin, while the broker provides the rest. This allows traders to control larger positions with a smaller initial investment.
However, it’s important to note that while leverage can amplify potential profits, it also amplifies losses, making CFD trading a high-risk endeavor that requires careful consideration and risk management.
CFD Trading Explained
When a trader opens a CFD trade, they are essentially speculating on the direction of the price movement of the underlying asset.
If the trader believes that the price will go up, they buy a long position. If they believe that the price will go down, they buy a short position.
The profit or loss of the trade is determined by the difference between the opening and closing price of the contract.
CFD trading allows traders to use leverage, which means they can control a larger position with a smaller amount of capital. However, this also means that losses can exceed the initial investment.
Buying or selling
The dichotomy that defines CFDs is the option of whether to buy or sell.
This is how traders speculate on the asset – by trying to predict the direction of an asset’s price movements.
As such, buying and selling CFDs represents the direction in which you believe the asset’s price will move.
When using buy positions, you are agreeing to sell an asset in the future, regardless of the price movement.
So, by opening a buy position, you are agreeing to buy units of a specified asset whether the price rises or decreases – this is how losses or gains are made.
As a result, if the price goes up, you are essentially “selling” the asset back to the broker with an increased value, making positive gains.
However, if the price of the asset was to decrease, you would be required to sell the same asset back at a lower price at the end of the trade, making a loss as a result.
Buy positions are also known as “long” positions, or “longing”.
Also known as a “short” position, “short selling”, or “shorting”, sell positions act in the same manner as buy positions but with an inverse effect.
This means you agree to sell an asset at a given price with the promise of buying the same assets back at the end of the trade. The difference – upwards or downwards – is then used to calculate the gains or losses.
So, if the price of an asset decreases below the price at which you opened your sell position, the CFD position would be in profit.
Of course, if the asset increases in price, you would make a loss.
You will often be given access to leverage when trading CFDs.
Rather than paying for the entire position upfront, you may use leverage from your broker to increase the size of their position.
This amount is simply “borrowed” for the specific trade and you do not keep the full amount – only the amount by which the position has increased.
Leverage allows you to pay for a fraction of the position size while trading with a greater amount.
Your returns will then be magnified by the leverage you have taken. Any losses will also be magnified, which is why leverage is often considered a double-edged sword.
Leverage is expressed as a ratio in order to indicate the amount by which your position size is increased.
For example, if your account had funds worth £1,000 and you opened a trade using a leverage of 10:1, your position size would be £10,000 as a result.
It’s important to note that if a CFD broker in the UK is regulated by the Financial Conduct Authority (FCA), retail investors are limited to leverage between 2:1 and 30:1. This is to protects non-professional investors from taking on more leverage than they can manage.
When trading with leverage, you may see the term “margin” used. This is the amount of the trade that you are required to use upfront to make a leveraged trade.
For example, the £1,000 in the trade I mentioned above would be the margin for that trade.
The margin is calculated as a percentage or ratio, and displays your level of exposure during a trade.
Negative balance protection
Leveraged positions can result in incurring a loss greater than the value of funds in your account, resulting in a negative balance.
Negative balance protection is a feature used to protect traders from losing more money than what is in their account, even during erratic price movements.
FCA-regulated CFD brokers are required to offer “negative balance protection”.
Negative balance protection automatically liquidates or closes any positions before they cross into a negative balance.
This is useful when trading international CFD markets, since you may not always be able to keep tabs on your trade when considering time differences.
For new CFD traders, or anyone who seeks to limit their risk exposure, this feature could be especially useful.
What assets can you trade using CFDs?
Many brokers in the UK facilitate CFD trading across a range of different assets including:
CFDs vs futures contracts
The main difference between CFD trading and futures contracts is the temporal aspect of futures. While both rely on speculating potential price movements, either upwards or downwards, futures contracts have a set expiry date from the start.
This is different to CFD contracts, which can be held as long as you wish.
That said, something these two methods of trading have in common is their respective partnerships with leverage. Both CFDs and futures contracts are often traded using leverage in order to increase position sizes.
Another similarity is the fact that you don’t own any of the underlying assets that you are trading and you only receive the gains or incur losses as a result of the price movement, not the asset itself.
Futures can involve the underlying asset, but rarely do in practice.
Is trading CFDs a good idea?
CFD trading may be a good idea if you are an experienced trader and understand financial markets. However, they are typically seen as a high-risk strategy, and it will often require a lot of practise to use them safely.
This is because of the risk involved with setting correct trades, and the potential danger of taking leveraged positions.
There is a risk you could lose money when using leverage, as gains or losses may occur faster than you expected. It could be hard to close a position if the price starts moving quickly.
With negative balance protection, you reduce the risk of owing the brokerage or exchange money as the result of an unsuccessful trade. However, it’s still possible for your entire account to be liquidated if you don’t have sufficient margin to cover any losses.
Therefore, it’s important that you fully understand how CFD trading works and the risks involved. Brokerage sites in the UK are required to clearly display how many retail investor accounts lose money when trading CFDs on their platform, a figure that’s typically between 50% and 80%.
Because of the potential dangers it poses – mainly to inexperienced traders – trading CFDs is actually illegal in the United States.
Although, if you have experience trading CFDs or have practised enough to feel confident in your ability to safely trade with CFDs, they could provide a useful way to speculate on the price of assets in the short term.
In addition, if trading with larger position sizes is important to you, it can enable you to speculate with much larger amounts.
Pros and cons of trading CFDs
It can be useful to consider the advantages and disadvantages of trading CFDs.
Trading with a larger position size
Due to leverage, traders are able to increase their position size without committing the amount of funds that would otherwise be required.
This means you could trade larger sums without needing them in your CFD trading account.
CFDs have no time limit
CFDs include no stipulation on a time or date when a position should be closed. Instead, the trader simply places an order in the opposite direction at the price they wish to close at.
You can speculate on the price moving in either direction
When investing in stocks, you’re typically hoping for the value of the company to increase in order for the value of your shares to increase.
Meanwhile, CFDs can allow you to speculate on prices increasing or decreasing.
This could help provide some flexibility to your strategies if you think an asset’s price is destined to fall.
Trading CFDs involves the risk of liquidation
If you use too much leverage, or you simply have the wrong hypothesis for how an asset might move, trading CFDs could result in your portfolio being liquidated in order to cover the unrealised losses to a certain point.
Once your portfolio can no longer cover the losses outright, if you have negative balance protection, the remainder of your funds will be forcibly taken to cover your loss, as the brokerage or exchange has no evidence you can in fact pay them.
Spreads could instantly decrease your initial position size upon opening a trade
During price movements, it can be difficult for brokerages and exchanges to execute orders at a very specific price if the current price is moving quickly.
Because of this, it’s likely that your position size will be slightly reduced as a result of the price spread. It could be argued that this makes a winning trade an uphill battle from the start, which only reinforces the need for practise.
You may need to constantly monitor your position
Leveraged trades may need to be closely presided over to maintain a healthy leverage ratio and avoid liquidation.
This makes it a potentially intensive, time-consuming way to trade.
What are the costs of trading CFDs?
There are various fees and trading costs you may face when trading CFDs.
Each order executed during a CFD trade will often incur a commission fee that goes to the broker. This will vary from broker to broker, and is likely to be charged on both the opening and closing trades of the position.
This cost is normally exclusive to trading CFDs on stocks, and there may also be a financing cost for giving you access to leverage.
If you trade with large positions, this fee could become significant and is worth factoring into your trading strategy.
In trading environments, assets are given different prices besides the market price – the “bid” and “offer” prices. These are both important to understand in order to get a well-rounded view of the fees associated with trading CFDs.
Essentially, the spread is the difference between the price at which you buy an asset and the price at which you sell. This moves with the price of the asset itself and may widen or narrow at any point.
In order to trade the asset, you must pay an initial fee that covers the spread when your position was opened.
This happens every time you open a position, meaning you are likely to be at a small loss automatically.
If the market moves rapidly, either up or down, the spread may be higher.
Where can I access CFD trading?
CFDs can be accessed through a broker.
A broker acts as the intermediary party between you and the underlying market. Through it, you are given access to the services required to trade CFDs.
This is done by the broker providing the trading platform on which you can create the conditions of your position – the buy price, sell price, or stop-loss for example.
You may need a specific CFD account for this, although this may depend on the CFD trading platform.
It’s common for these CFD providers to take fees that cover the costs of providing the service they do. It’s worth making sure you’re aware of how much you’re likely to pay as a result of this fee.
If you seek to trade shares or stock indices with CFDs, your ability to do so may be limited by the trading hours of the specific market.
For example, if you wanted to use a CFD to speculate on the price movement of Apple, since it is an American-listed company, your ability to do so is restricted by United States trading hours.
CFD trading FAQs
Is CFD trading good for beginners?
Are CFDs legal in the UK?
The value of your investments (and any income from them) can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance. Investments should be considered over the longer term and should fit in with your overall attitude to risk and financial circumstances.
Forex & CFDs are complex products, not suitable for everyone and come with the high risk of losing money rapidly due to leverage. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.
Cryptocurrency is not regulated by the UK Financial Conduct Authority and is not subject to protection under the UK Financial Services Compensation Scheme or within the scope of jurisdiction of the UK Financial Ombudsman Service. Investing in cryptocurrency comes with risk and cryptocurrency may gain in value, or lose some or all value. Capital Gains Tax may be applicable to profits from cryptocurrency sales.