A CFD is a contract between two parties where a buyer will pay a seller the difference between the opening and closing price of the agreed instrument.
CFD stands for ‘contract for difference’ and is commonly used by brokers and their clients to access thousands of markets worldwide. They offer exposure to so many markets because they are a derivative of the underlying asset, meaning that those involved in CFD exchanges do not own that underlying asset.
How does CFD Trading work?
The concept of trading CFDs is just the same as trading any other market, if you buy low and sell high, you profit from the difference in value. If you buy high and sell low, then you lose from the difference in value.
The parties involved in a transaction are speculating on the direction of the underlying market. If you open a long position, or are buying the CFD, you are anticipating a price increase in that market. Should the market rise in value, you can then sell the contract at a higher price and make a profit.
The amount you profit will depend on the number of contracts you buy. The more you buy, the more profit you will make from that exchange or trade.
Should the market fall and you sell the contract below the price you bought it, you are then required to pay the difference in value and ultimately make a loss.
Going short in CFD trading
If you are anticipating a price decrease in a market, trading CFDs allows you to profit from this as well. Unlike traditional share dealing which only allows you to buy a market, trading CFDs lets you sell an asset without ever owning it.
“How can you sell something that you don’t own?”
To sell something you don’t own, you need to borrow the asset first, once borrowed, you can then sell it and buy it back at a lower price. Then you can return the asset to the party you loaned it from, profiting from the decrease in price.
In CFD trading, you are simply speculating on the price and therefore don’t need to borrow from anyone, shorting a CFD entails an agreement between two parties that should the contract closing price be below that of the opening price, the seller (you) will receive the difference in value.
Trading CFDs with leverage
A similar principle to short selling, trading with leverage is, again, a version of borrowing. It allows a trader to only put forward a percentage of the whole trade cost.
For example, if you wanted to buy an asset for £1,000, you can put up £100 and the broker, or party offering you the leverage, can lend you the remaining £900 so that you can take the position. You would be leveraged at 100:1.
Hedging with CFDs
For investors, CFDs are a great tool to hedge your position or portfolio. If in the short term you anticipate a decrease in your overall position, you can hedge against this by purchasing a CFD in the opposite direction. The ability to short a CFD makes them a very popular instrument for investors around the world.
An example would be if you owned physical shares in Apple, you expect over the long term that this stock will appreciate in value but short term you anticipate a decrease. You can keep your physical stocks (and not pay any transaction fees) and sell a CFD of the stock. This way, if you see a decline in the price, you would offset a loss in the physical stock by a profit in the CFD, and thus hedged your position.
Lots of CFD markets
A huge factor in the popularity of CFDs is the fact that you can trade a wide range of markets. Types of products that are available in CFD format include; Forex, Commodities, Indices, Stocks, cryptocurrencies and ETFs. This wide reach means that you can trade thousands of markets, normally from one platform, therefore negating the need to open several brokerage accounts.
Costs of trading CFDs
Unlike other products, CFDs don’t charge fees or commission on most products, the main cost comes in the form of a spread. This is the difference between the buy price quote and sell price quote provided by the broker. The tighter together they are the less the price needs to move before you are in profit.
Another cost that is attached to trading CFDs is a holding fee, this is added at the end of each trading day and can be either negative or positive, depending on the direction of the trade.
Depending on your broker, sometimes a commission can be charged when purchasing share CFDs, the spread is removed, and you enter at the underlying market price.
Advantages of CFD trading
· Trading with leverage
Trading with leverage can simply make your money go further. Having the ability to borrow and profit from a considerably larger position can have a really positive impact on your account balance. Leverage also gives you exposure to financial markets you normally would not be able to access.
For instance, if you are a retail trader and you want to profit from the price fluctuations in the forex market without leverage, you would need huge capital behind you to make any substantial gains. And as a percentage of your account, any profits are likely to be small.
· Going Short
As highlighted above, the ability to short a market means that you can profit from a market in either direction, therefore increasing the number of trading opportunities available to you.
Shorting also means you can use CFDs as a hedging tool, helping to balance your portfolio in the short term.
· Easy multiple instrument access from one platform
Having access to any market you want from one platform makes trading and balancing your portfolio easier. When you can see exactly what you have open in one place, you can make quicker and better-informed decisions. It also allows you to calculate your total risk accurately.
CFDs makes access to these markets very easy, the process of buying is standard across most products, so once you understand this then accessing any market is simple.
· Low fees
Fees attached to trading CFDs are minimal. The most common cost is the spread, which is paid to the broker every time you execute a trade, however due to the competitive nature of the broker market, it is easy to find brokers who offer tight spreads.
Some share CFDs can charge a commission but if this is the case, the spread is normally removed from the charge.
Disadvantages of CFD trading
· Risks of leverage
In the same vain that leverage offers you huge upside, there is also a downside to trading with leverage. You can lose money just as fast as you make it and for novice traders especially, over leveraging can prove to be an issue. It is imperative to understand leverage and risk management before you begin trading, over leveraging can often result in trading accounts being lost very quickly.
If you buy an asset without leverage and the value halves, then the value of your investment is also halved. If you buy the same asset with 2:1 leverage, by the time it’s value halves, you have lost your entire investment in that instrument. Should the price go back up, you would not recoup your losses whereas the party who bought without leverage would see his losses decline and potentially go into profit.
· No ownership = no voting / dividends
The fact that you do not own the underlying asset means that you don’t have any control of that asset. When you buy a share in a company, you own a physical part of that business and have a right to vote (depending on the share type) and a right to a share in the profits, or dividends. Therefore, CFDs are used purely to speculate on the price of an instrument, no other profit can come from them.
· Spreads can vary
Whilst spreads are the only charge most of the time, they can vary between brokers and trading conditions. During high volatility periods in the financial markets, you will often see spreads increase, therefore costing you more to enter and exit a market than it would in lower volatility conditions. This is dependent on the broker you use but it is something that you should be aware of.
Should you trade CFDs?
Trading CFDs certainly has its advantages and whilst it will depend on the trader’s preferences, there is certainly a strong argument to have the option to trade CFDs when opening a brokerage account.
Experienced traders that have a portfolio of investments will find CFDs a great tool to help manage that portfolio, using them to look after the short-term fluctuations whilst the physical stock can look after the long-term strategy.
For novice traders, it is often advised to use CFDs because you do not need to put the full value of the trade down to enter a position. This means that your initial deposit can be minimal, and you don’t need to overextend your finances to start trading.
We would always recommend understanding the principle of risk management before trading any product and especially if you are going to use a leverage product such as CFDs.