What is CFD trading?
CFD trading describes the process of traders buying and selling CFDs with the aim of making a profit.
CFDs are a financial product that allows traders to speculate on the price movement of an asset without owning the underlying asset.
Instead of buying the asset itself, you enter into a contract with a broker to exchange the difference in the asset’s opening and closing prices.
CFD trading enables traders to open a larger position size as they offer the advantage of leverage, which is also known as margin trading.
They also allow traders to trade either long or short, which means they can take advantage of either rising or falling prices.
What is a CFD?
CFD stands for Contract for Difference. They are a financial product or ‘instrument’ offered by many brokers around the world.
They are a derivative product, which means their value is derived from the value of the underlying asset. They allow traders to speculate on the price movement of an asset without actually owning the underlying asset.
With CFD trading, you don’t own the asset, you just get exposure to its price movement.
In essence, they are a contract between the trader and a broker, settling the difference in the asset’s value between the entry and exit points of the trade. Hence the term CFD trading.
For example, if you buy 10 Apple share CFDs, you don’t actually own 10 Apple shares, just the CFDs which represent the value of those underlying shares.
If you buy Bitcoin CFDs, you don’t actually own any Bitcoins. You just own the right to profit from the difference between the price you purchased the Bitcoin CFDs for, and the price you sell them for.
Markets available to trade using CFDs
CFDs are available to trade for a wide range of financial assets including:
- Forex
- Indices
- Commodities
- Gold and other metals
- Cryptocurrency
- Stocks
- ETFs (Exchange Traded Funds)
There are several key things to understand when you first start trading CFDs. The first of these is the use of leverage.
What is leverage with CFD trading?
CFDs allow you to trade using leverage, which means you don’t have to have the full value of the trade in your trading account.
Effectively, the broker ‘loans’ you a percentage of the cost of your trade.
This percentage is known as the ‘margin’ on offer, and can range from 2% right up to 80% or more.
The higher the margin figure, the higher the percentage of the trade value you have to physically have in your trading account when trading CFDs.
For example, if you were trading on 2% margin, and your trade was worth $100, then you would only have to have $2 in your trading account to cover the cost of that $100 trade.
If you were on 80% margin, you’d have to have $80 out of the $100 value of the trade.
Controlling your leverage when trading CFDs
Leverage magnifies your CFD trading power, potentially allowing you to make a larger profit. However, it amplifies the potential for losses too.
This makes learning risk management skills important to every CFD trader.
It’s also important to understand that your trading profits or losses are based on the full value of your trade, so you can potentially lose more than the value of the trade you place.
Because of this, it’s critical to remember that you don’t need to max out your leverage, or use all the leverage that is on offer.
It can be a good idea to make small trades that only use up a portion of your available margin, particularly if you are a beginner trader.
Overnight financing for CFD trading
When you trade CFD’s your position will be subject to overnight financing costs.
These costs will reflect the underlying interest rate of the market you are trading.
For example, if you are trading UK stocks the interest rate will be based on the interest rate in the UK.
Interest rates are usually subject to a markup by the broker who is providing the CFD. For example, a broker may mark up the interest rate by 1%.
While you may normally be paying interest, there are times when you will receive interest. For example, if you are short trading a stock, you could receive interest, although in this case you would have to pay any dividends due on a stock CFD.
If you buy a high interest rate currency, and use it to buy a low interest rate currency (such as AUD/JPY, for example) you can earn interest on your trade. This is known as a ‘carry trade’.
If you want to trade with no additional markups or fees when trading CFDs, find out about MarketMates’ Subscription-Based Trading.
Ability to go long and short with CFD trading
CFDs allow you to trade in both directions, both up and down, or long and short.
Short CFD trading means that you place a trade hoping for a price reduction in the asset you are trading. It means you want prices to go down, not to go up.
It is the exact reverse of a long trade, where you’re hoping that prices will increase.
The diagram below shows a potential short trade entry, at the top of the long red candlestick as the prices is going down, and also a potential long trade entry on the green candlestick, when the price is rising up.
What happens if you short a trade and the price goes up?
When trading CFDs, if you decide to take a short position, and the price of the asset rises, you’ll make a loss.
Remember, the loss will be based on your total position size, not just the portion you fund from your account.
Trading CFDs on margin using leverage is a popular trading strategy which can assist you to make larger profits than you would be able to if there was no leverage involved.
However, you should be aware of the increased risk, because not only are your profits magnified, but your losses can be magnified too.
Is trading CFDs suitable for beginner traders?
Trading using CFDs is suitable for beginner traders as long as you understand the implications of using leverage to trade, and don’t over-commit yourself.
The benefits of trading CFDs are:
- they enable you to access a wide range of markets
- they enable you to amplify your trading potential using leverage
- you’re able to make both long and short trades, all from one account
However, it’s vital you understand the implications of using leverage before you start trading, and don’t feel you have to use all the leverage available to you.
My advice is to start with small trades, and build up your position size as you gain experience.
It can be a good idea to practice placing trades in a demo account first, so you learn how leverage works in a safe environment.
You’ll also need to learn how to trade in a safe way using a variety of risk management techniques.
If you like this article, and would like to learn more, then sign up for our newsletter or join over 42,000 other traders and get The Advanced Forex Course for Smart Traders 2.0. It’s 100% free.
Till next time, safe trading!
Glossary
Here’s an explanation of some common FX trading words:
ASX – the Australian Securities Exchange, Australia’s stock market
BC – base currency, the first currency in a pair
Brokerage fee – a fee you pay to a stock broker or brokerage site each time you use their platform to buy or sell an asset
Bear market – describes a market environment in which the majority of prices are falling
Bull market – an optimistic market in which most prices are rising
Cable – a slang market term for one of the most popular currency pairs – GBP/USD
Carry trade: A strategy where a trader borrows in a currency with a low interest rate and invests in a currency with a higher interest rate to profit from the interest rate difference
CC – counter currency, the second currency in a pair
CFD – a ‘Contract for Difference,’ which is a type of derivative financial product that is traded based on the value of an underlying asset such as a currency pair or company share or cyptocurrency
Correlation: The statistical relationship between two assets, for example two currency pairs, indicating how they move in relation to each other – either positively, negatively, or not at all
Cryptocurrency – a form of virtual currency which only exists in the cyber world. Cryptocurrencies can also be traded online through CFDs in a similar way to standard FX trading
CPI – Consumer Price Index, which reflects the inflation rate of a particular country, and is a very important market indicator in FX trading
Day trading – a trading strategy that involves buying and selling shares in one day, and closing all positions before the end of the trading day
Derivative – a financial product that is based on the underlying value of another asset. CFDs, options and futures are all examples of derivatives
Forex brokerage: A company or platform that provides access to the forex market, facilitating the buying and selling of currencies for traders
Forex or FX trading – foreign exchange trading, converting one currency to another in order to profit from price changes
Futures contract – a contract to buy or sell an asset at a specified future date for a specified price
Greenback – a FX slang term for the American dollar, based on the colour of American $1 notes
Hedge – an investment strategy designed to offset or reduce your exposure to risk. It is related to the phrase ‘hedging your bets’
Leverage – using ‘borrowed’ money to invest so you can trade a larger position with less initial outlay. Most FX brokers offer leverage starting from 5% up to 60% or more
Loonie – the slang FX market term for the Canadian dollar (because Canadian dollar coins formerly pictured a loon on them)
Margin: The amount of money required to open and maintain a leveraged position, often expressed as a percentage of the total trade size
OTC – ‘over the counter’ – which describes the global forex market method of operation, where there is no centralised exchange, but rather trades take place directly between two parties through an electronic network connecting traders all over the world
Share trading – buying and selling shares in public companies through a stock exchange
Short trading: Selling an asset with the intention of buying it back later at a lower price to profit from a reduction in the price
S/R – support/resistance. This describes specific price levels using technical analysis on a trading chart. Support is a level below the current price which has previously acted as a floor or lowest selling point. Resistance is a price level above which the price has previously shown reluctance to climb
Slippage – The difference between the expected price of a trade and the actual price at which it is executed,with the difference often due to market volatility or delays
SL Order – Stop loss order – a type of trading order which automatically kicks in at a certain price and closes a trade to prevent catastrophic loss
Sterling – another name for the British pound
Swap fees: Costs incurred when holding a position overnight, related to the interest rate difference between two currencies in a forex pair
Take a Position – this describes the action of opening a trade – you are said to ‘take a position’ when you choose to open a trade
TP Order – Take profit order – a price order which is set which automatically closes a position to take the profit made on that trade
Volatility – a measure of how much the value of a particular asset fluctuates on a regular basis
Sources
Marketmates uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial guidelines to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy.
- Investopedia: Contracts for Differences (CFD): Overview and Examples https://www.investopedia.com/articles/stocks/09/trade-a-cfd.asp
- Moneysmart – Australian Government website https://moneysmart.gov.au/investment-warnings/contracts-for-difference-cfds
