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CFD or Contract for Difference is a contract (usually short-term) between an investor (a buyer) and a spread betting firm or an investment bank (seller). It provides investors and traders with the opportunity to earn money without actually owning the asset but from its price movements.
CFD trading comes with many benefits, and some of the most important ones are:
It allows you to trade on margins.
You can go long if you calculate that the prices of a certain asset will increase.
You can go short if your measurements tell you that there are high chances that the prices of a certain asset will go down.
You can use contracts for difference to hedge your existing portfolio. If you want to learn more about CFD trading, then continue reading this article till the very end. It contains everything you need to know about CFD trading.
What is CFD Trading?
CDF is a contract between an investor/trader and seller that demonstrates that the trader will need to pay the price difference between the current value of the asset and its value at the time of contract to the seller. It's important to keep in mind that instead of considering the asset’s value, CFD only deals with the price difference between the trade’s entry and exit points. Both parties exchange the asset’s price difference at the end of the contract. Trading CFDs Just like any other trading style, it also means that you’ll either earn profit or experience loss depending upon the movement direction of your chosen asset.
How Does CFD Work?
Now that you understand what CFD trading is, it’s time to discuss how it actually works.
There are four basic components of CFD trading which are:
Spread
Deal size
Duration
Profit and Loss
As mentioned earlier, CFD (Contract for Difference) is a contract that takes place between two parties which are the buyer or trader and the seller that can be your desired brokerage.
Spreads
There are two different prices involved in CFDs:
Buy/Offer Price: The buy/offer price allows the trader or investor to open a long CFD
Sell/Bit Price: The sell/bid price is the price at which the trader can open a short contract for difference.
The sell prices are slightly lower, and the buy prices are slightly high than the currently available market price of a certain asset. The difference of these prices is known as a spread which covers the cost to open a CFD most of the time. In other words, the buy/sell prices are adjusted accordingly in order to reflect the trading cost. The exception to this is the brokerage’s share CFDs that the trader is working with. It’s important to keep in mind that almost all the brokers charge their share via commission instead of spread.
Profit and Loss
You can calculate your profit/loss by multiplying the total number of contracts by each contract’s value and then multiplying the answer by the difference between the asset’s opening price and its closing price. You can use the following formula as well.
Profit/Loss = (Number of Contracts) x (Value of Each Contract) x (Asset’s Closing Price – Asset’s Opening Price)
You’ll also need to subtract the fees or charges that you have paid to the brokerage in order to calculate your entire profit or loss from a certain trade.
How Do CFDs Empower Your Trading?
There are many positive aspects of CFD trading, like it comes with a low entry threshold, low margin requirements, and a wide range of easily accessible trading instruments. Here’s how CFDs improve your trading experience.
Leverage
CFDs provide you with the capability to invest a small amount of money to earn large gains by increasing the transaction sizes considerably. In simple words, you can opt for CFD trading to work with your available capital more effectively and efficiently as compared to other trading types. CFD can actually deliver quicker and higher returns than other investments.
The similarity of the Shares to the Underlying Market
As mentioned, CFDs mimic the trends of the market fairly closely. Purchasing the actual share in the company is very similar to buying one share CFD. For example, buying 500 share CFDs is equal to buying 500 shares. Your position is adjusted when you perform the trading of your CFD shares which offsets the dividend payments' effect. It's also important to bear in mind that you don't possess the privileges of the shareholder because, with CFDs, you don't own the share.
Hedging Portfolio
Suppose you own 500 shares of a certain company and you want to hold for the long term. However, you calculate in the short term that the company is on the downward dip path. In such a scenario, CFD allows you to open a short position in order to offset your potential losses. If your calculations were correct, then you'll earn a profit, and CFD will also offset your losses. Whereas, if you were wrong, then your losses will be offset in the future and can close the position right away as well.
You can Go Short
CFD provides you with a lot of flexibility as compared to other trading types. Not only do you have the option to trade on the rising market, but you can also perform trading on the falling one as well. You can trade on the buy price if you think that the market is going up and vice versa.
Range of Markets
You can perform CFD trading in over 16,000 markets that offer commodities, Forex, crypto, indices, etcetera. CFDs allow you to perform trading even outside business hours, and you also don't need access to various platforms. Moreover, the trading cost is also cheaper as compared to the traditional market.
These are some of the most significant reasons why CFD trading is one of the best trading types.
Along with its tremendous advantages and upsides, CFD trading also comes with its own downsides, such as lack of ownership of the underlying assets, excessive leverage. Moreover, this type of trading also carries a high-risk level. Therefore, CFD trading is not suitable for everyone. In CFD trading, your potential losses can be limitless, which means you can lose more than what you initially deposited.
As mentioned earlier, CFD trading is leveraged, which means that along with greater returns, it can also lead you to greater losses as well. It's certainly possible for you to allocate stop losses to each trade. But the fact of the matter is that they're not guaranteed and won’t work the way you expect because of the market slippage and gapping.
CFD, being a leverage trading type, involves risk by nature. It’s important to keep in mind that you should only invest your money in CFD trading if it suits your circumstances and meets your investment and financial goals. If you don’t understand the contract for difference perfectly, then we recommend you not to invest unless you understand everything. It's not possible to guarantee the performance and future behavior of any financial product. You can either earn or lose more money than you invested.
Diversifying your portfolio is also a wise decision, and we don't recommend you to put all your eggs in one basket. Consider spending your money between different investment types in order to minimize the risk of losing everything.
The selling price of BHP is 27.59 US dollars, and the buy price is 27.60 US dollars. You expect that the BHP share price will go up, and you decide to buy 2000 share CFDs which is equal to buying 2000 shares of BHP. Moreover, you only need to cover the margin instead of putting up the shares’ full value. So, if the margin factor of BHP is 5 percent, your margin will also be 5 percent of your trade’s total exposure (2000 share CFDs x 27.60 US dollars = 55,200 US dollars), which is 2760 US dollars.
Buying a Share CFD: BHP on IG Markets
In Case of Correct Prediction
If your prediction is correct and the BHP share price actually goes up, you close your position at 29.60 US dollars (with the selling price of 29.60 US dollars and the buy price of 29.61 US dollars). In order to calculate the profit, you’ll need to multiply the difference between asset's opening price and the closing price by the size of your position, which in this case will be:
29.60 US dollars - 27.60 US dollars = 2 US dollars
Then you’ll need to multiply the answer (2 US dollars) by 2000 CFDs to get the final profit which will be:
2 US dollars x 2000 CFDs = 4000 US dollars
Keep in mind that you’ll need to subtract the overnight finance charges and the commission fee.
In Case of Correct Prediction
In Case of the Wrong Prediction
If your prediction is wrong and the BHP share price drops, you plan to sell 2000 CFDs at 26.60 US dollars and cut your losses. Here, your position has moved 1 US dollar against, which means that the loss will be 2000 US dollars. Moreover, overnight charges and commission fees will also be added to your loss.
Bear in mind that CFD trading is not legalized in all countries. Therefore, it's important to make sure whether your country allows it or not. Additionally, if you can legally perform CFD trading in your country, you'll also need to fully understand the rules and regulations to keep yourself from all unwanted situations.
CFD Trading in the US
If you don’t already know, people from the USA cannot perform CFD trading because it’s strictly against the securities laws of the country. CFDs and other over-the-counter financial instruments are heavily enforced by the SEC (Securities and Exchange Commission) and regulated by legislation (Dodd-Frank Act).
CFD Trading in EU
CFD trading in Europe is legal, and brokers who allow the users to perform this type of trading must be regulated by CySEC (The Cyprus Securities and Exchange Commission). Moreover, online brokerages that offer their services in the United Kingdom must also be regulated by FCA (Financial Conduct Authority) to offer CFD trading.
The regulations that these regulatory authorities impose not only increase the knowledge and awareness among traders. But they also protect the privacy and funds of traders by reducing the highly risky nature of CFD trading.
Brokers offering CFD trading functionality must also meet strict fiscal and capital requirements. They must also keep their client funds in separate accounts and work with the top-tier financial authorities.
As mentioned earlier, in order to perform CFD trading, you'll need to pay the volume-based commission to the brokerage, which is usually near 0.1 percent. In some cases, brokers charge a fee for each contract, and in some cases they even offer CFD trading without commissions. For more accurate information, contact the broker you are interested in. Other than the commission, the finance charge is also associated with CFD. Bear in mind that you’ll only need to pay the charges when the transaction occurs.
Commission
The commission is charged when you open and close a CFD position. Regardless of the buying or selling side, the commission is charged on the same counter during the same day instead of charging the commission on a daily basis.
Finance Charge
The finance charge reflects the cost that you need to pay for holding an underlying position overnight. It depends on the entire position's value of the contract, which is marked as the day's closing price. If you close your bought position within the same day, then you won't need to pay any finance charge. It means that this type of cost doesn't exist in CFD day trading.
Best CFD Brokers in 2024
One of the most important factors that can make or break your CFD trading experience is the selection of the brokerage. Not only do you need to choose the trusted and regulated online trading platform for CFD trading, but you also need to make sure that it meets all your needs and investment, and financial goals. That’s why we have come up with three of the best CFD brokers in 2023 for your convenience.
eToro is primarily designed for CFD trading, and it's one of the biggest online brokerages that you can use for social investment. It's your best choice if you are interested in CFD trading. Currently, this platform has more than 4 million active users from 140 different countries all around the globe.
While dealing with this brokerage, you can rest easy knowing that your investments are in safe hands. eToro is regulated by both CySEC and FCA that makes it a trusted and reliable online trading platform for CFDs.
XM is yet another great online brokerage that has been serving CFD and Forex traders since 2009. Currently, this online broker flaunts more than one million active users from all around the world. It's not only considered as one of the best online brokers for CFD, but it's also popular for its reliability and integrity.
XM is regulated by CySEC, ASIC (Australian Securities and Investments Commission), and IFSC (Financial Services Commission of Belize), and it can be your best choice for CFD trading in 2023.
IG Markets is also a great choice, and it claims to be the best CFD trading platform out there. The truth is that it's not easy to find any online review from both experts and traders that disagree with this claim. It also serves millions of active users from around the globe, and it's regulated by FCA, Germany's BaFin, which is a Federal Financial Supervisory Authority, NFA, etcetera.
2.5 percent for standard CFD contracts
and 3 percent for minis
Stock CFDs
1,240
Stock markets
8
Summary
CFD trading offers a number of potentially lucrative and distinct benefits to investors and traders. Along with the significant potential rewards, CFDs also represent a significant risk that you must consider before opening a position. You must research investments comprehensively, follow the best CFD trading practices and exercise caution before putting your capital into CFD trading. It’s also equally important to choose the right brokerage that comes with risk-limiting features and doesn’t forget to and understand the commission and fee structure. This way, the chances of maximizing your profit through CFD trading can substantially increase.
FAQ
Is there any cost of performing CFD trading?
Yes, you need to pay commission and overnight charges as well to your brokerage while performing CFD trading. Bear in mind that commission is charged on each trade, and opening and closing are considered as two different trades.
Is CFD trading or Investing Safe?
CFD is basically a derivative product that monitors the price of a certain asset, and you being a trader or investor doesn’t actually own the asset. That’s why it’s critical to choose the right CFD brokerage.
Can I become rich with CFD trading?
It solely depends upon the way you manage your funds. CFD trading can undoubtedly help you to maximize your earnings, as most of the CFD brokerages come with high leverage and a low-margin policy. At the same time, CFD trading can also be very dangerous as you can lose more than you deposited.
Why do CFD traders lose money?
There are only two possibilities in all types of trading. You either earn profit or lose money and all types of reasons play their part in the losses that include poor trading strategy, lack of knowledge, bad timing, poor money and risk management, etcetera.
Chinmay Soni is a financial analyst with more than 5 years of experience in working with stocks, Forex, derivatives, and other assets. As a founder of a boutique research firm and an active researcher, he covers various industries and fields, providing insights backed by statistical data. He is also an educator in the field of finance and technology.
As an author for Traders Union, he contributes his deep analytical insights on various topics, taking into account various aspects.
Dr. BJ Johnson is a PhD in English Language and an editor with over 15 years of experience. He earned his degree in English Language in the U.S and the UK. In 2020, Dr. Johnson joined the Traders Union team. Since then, he has created over 100 exclusive articles and edited over 300 articles of other authors.
The topics he covers include trading signals, cryptocurrencies, Forex brokers, stock brokers, expert advisors, binary options. He has also worked on the ratings of brokers and many other materials.
Dr. BJ Johnson’s motto: It always seems impossible until it’s done. You can do it.
Mirjan Hipolito is a journalist and news editor at Traders Union. She is an expert crypto writer with five years of experience in the financial markets. Her specialties are daily market news, price predictions, and Initial Coin Offerings (ICO). Mirjan is a cryptocurrency and stock trader. This deep understanding of the finance sector allows her to create informative and engaging content that helps readers easily navigate the complexities of the crypto world.
