A Contract for Difference (CFD) is a financial derivative where the trader and broker agree to exchange the difference between the opening and closing prices of the asset. Traders speculate on the price movement without owning the actual asset. This is because of the leverage that gives investors control over higher capital.
It’s a smarter way to trade market movement without owning the asset but still chasing the profit.
However, CFD trading has many benefits, such as immediate execution, flexible trading hours, and exposure to financial markets.
If you're someone with a bit of a trading background, CFDs can give you wider market exposure and flexibility. But if you’re just starting out, don’t worry, we’ve got you covered.
In this beginner’s guide, we’ll walk you through the essentials of CFD trading, from how it works to its benefits and risks, and provide step-by-step guidance to help you start your trading journey.
Key Points
- A Contract for Difference (CFD) is a trading agreement between an investor and a broker to exchange the difference in the price of an asset from the time they open the trade to when they close it, without actually owning the asset.
- A CFD broker is a company or platform that facilitates traders to trade CFDs, acting as a financial intermediary. In technical terms, a financial intermediary.
- Leverage is one of the core advantages of CFD, along with low capital requirements, flexible trading as flexible trading hours, and access to global market assets.
- Overnight cost, liquidation, and volatility risk are some of the potential disadvantages.
What is a CFD (Contract for Difference) & CFD Trading?
A contract for difference is a financial contract or instrument between two parties where they exchange the difference in the price of an asset from when the trade opens to when it closes, without owning the actual asset. This is more like an agreement and often between investors or traders and brokers in the global financial markets.
In a simpler version, a CFD, or CFD trading, is a deal between a trader and a broker to make money by guessing if a price will go up or down; rather than asset ownership. Traders speculate on the financial product price movement to make a profit. This nature of CFD makes it a capital-efficient trading approach.
This method uses leverage, which lets traders control a large amount of the market with a smaller initial payment, called the margin. While leverage can increase the potential profits, it also raises the risk of bigger losses, so it's important to be careful.
Common CFD assets are company shares, commodities, currencies (Forex), cryptocurrencies, or stocks. The price of the assets fluctuates, either going up or down depending on what’s happening with the actual asset.
What is a CFD broker?
A CFD broker is a company or platform that provides traders the platform and tools so they can buy and sell CFDs to trade. They are more like a middleman or financial intermediary.
The broker lets you trade with leverage, which means traders can control a big trade even with a small amount of money. It's called trading on margin. When the trade ends, CFD brokers handle the payment. Brokers facilitate the settlement of profits or losses directly into the trader's account. CFD brokers offer a convenient way to speculate on price movements without owning the asset.
The broker or broker company generates revenue through the spread, commissions, or overnight fees.
It is most important that you choose a reputable CFD broker that is regulated by financial authorities, as this ensures trading safety and reliability.
Basics of CFDs
You know that CFDs are a type of agreement where the trader does not own the actual asset. Now it’s time to know how CFDs actually work.
Also, let's understand the advantages with potential drawbacks of CFDs, with some examples to make your concept clear about CFDs.
How Do CFDs Work?
CFD is a type of trading where you don’t actually buy the real asset, like a stock. But you still get to trade based on its price movements.
Let’s say you want to trade a company’s stock. Instead of buying the actual shares, you enter a contract with a broker. The price may go up or down. Then you speculate on the price movement of the asset.
The value of the CFD follows the price of the real stock (called the underlying asset). When you open the trade, the asset has a price. That’s when you enter into CFD trading. When you decide to close the trade, the asset will have a new price. That’s your exit point. The difference between the two prices decides your profit or loss.
With CFDs, you can trade in both directions.
- If you think the price will go up, you go long (you “buy”).
- If you think the price will go down, you go short (you “sell”).
Also, every CFD trade has two steps:
- You open a position (either buy or sell).
- Later, you close it by doing the opposite. So, if you opened with a buy, you’ll close with a sell.
Advantages of CFDs
CFD trading comes with several advantages; among them, leverage is one of the biggest. Let's check the facilities you get with CFD.
1. Leverage:
With the leverage power, you get to trade big with less money. In simpler terms, your broker facilitates you by offering leverage, where you get to open a big position without needing the full amount of money. Here, even with a small movement in the price, you can get a big profit. With the potential drawback that if you speculate wrong, it can cost you a hefty amount of money.
Say, for example, you want to trade $10,000 worth of gold. You only have $500. Your brokers offer a leverage ratio of 1:20. This means that for every $1 you get to trade $20. Great, right? So with just $500, you can now control a $10,000 trade.
2. Low Capital:
You don’t need a huge amount of money to start. With just a small deposit, you can trade bigger. CFD makes it possible to enter into CFD trading with a small investment.
3. Explore Global Financial Markets:
You want to explore and trade on multiple assets. With CFD, you can trade stocks, forex, commodities, or indices all from one place. With the broker company providing the platform, explore global financial markets.
4. Hedging with CFD:
Worried about your current investment going down? Hedging is a risk management strategy that can save you. It helps you to reduce potential losses on an investment by taking a position in the market that offsets the initial investment.
5. Go Long and Short:
Get profit whether the market goes up or down. Buy when you think it’ll rise, sell when you think it’ll fall.
6. Immediate Cash Settlement:
The moment you profit or lose, get instant settlement without any delay. Your broker will do this for you. No delay at all.
7. Flexible Contract Sizes:
This is not mandatory; you only need to trade the amount. You can choose to trade what you want to invest in. You can adjust your position size according to their risk tolerance and trading strategy.
8. Trading Hours:
Regular financial market hours are fixed and vary slightly for each country. But in CFD trading, hours are flexible and can be extended based on the underlying asset.
Disadvantages of CFDs
With the benefits, you need to know about the potential risks of CFD trading so you can create your CFD trading strategy accordingly and reduce the risk of losing.
1. Counterparty Risk:
CFDs are traded over-the-counter (OTC). This means transactions are executed directly with a broker, not through an exchange. This raises counterparty risk, where if a broker fails or becomes insolvent, this will risk your money.
2. Liquidation Risk:
If your account balance falls below the required margin level, your broker may automatically close your open CFD positions. This is to prevent further losses. Most brokers issue margin call alerts before liquidation. So traders can add more funds to the account to keep the position open.
3. Overnight Cost & Gap Risk:
News or events after market hours can cause a big price jump (up or down) when the market reopens. This can lead to unexpected losses. Also, if you hold a CFD trade overnight, you’ll pay extra fees. Such as interest for long positions or borrowing charges for short ones.
4. Volatility Risk:
High market volatility can trigger sudden price swings. Thereby, managing trading becomes a bit difficult. During such times, brokers may increase margin requirements without prior notice.
5. Spread Cost:
Every time you open or close a CFD trade, you pay the difference between the buying (ask) and selling (bid) price. This is called the spread. Even if the market moves a little in your favor, small gains can get eaten up by the spread.
Terms Related to CFDS
Here are some common terms related to CFD that you will come across several times when trading CFD. So, it's better if you get to know them well.
Underlying Asset:
The real thing your CFD is based on is the financial instrument, like a stock, gold, an index, or a currency pair.
Margin:
The small amount of money you need to put down to open a trade.
Leverage:
It lets you control a large trade with a small amount of money. It can boost both your profits and your losses.
Stop-Loss Order:
An order that automatically closes your trade when the price moves against you by a specified amount, helping to limit potential losses. Traders set this order in advance.
Take-Profit Order:
A setting that automatically closes your trade when you reach your target profit. Traders set this rule to lock in the profit.
Overnight Financing:
A small fee you pay (or sometimes earn) if you keep your CFD trade open overnight.
Costs of CFDs
How to calculate or understand the cost of CFDs? Here are some terms.
Spread:
This is the difference between the price you buy at and the price you sell at. For example, if you buy at $100 and sell at $99.80, that 20 cents is the spread. Brokers earn from this gap.
Commission Fees:
Some brokers charge an extra fee on each trade. It can be a fixed amount or a percentage of your trade size, which is known as commission fees.
Financing Costs (Overnight Fees):
If you keep your CFD trade open overnight, you’ll likely be charged a small daily fee, which is the financing cost.
Slippage:
Slippage happens when the market moves fast, and your execution price of a CFD trade is different from what you expected.
Inactivity Fees:
If you stop trading for a long time (like months), some brokers may charge a small monthly fee. This is the inactivity fee just for having the account open and unused.
Withdrawal Fees:
When you take money out of your trading account, some brokers charge a withdrawal fee. This varies for different brokers.
Example of a CFD
So far, we have talked a lot about CFD. Now, check this CFD example to understand the whole concept better.
The Trade Setup
You see an opportunity in Netflix (NFLX) shares at $300 per share. After analyzing everything, you think the price will rise. Instead of buying the shares directly, you trade CFDs. There is 5x leverage. So you can trade $5,000 with just $1,000.
Opening the Position
You open the position with 16.66 CFDs. Your broker charges a 0.09% commission. So, you need to pay $4.50 to enter. You also pay a daily financing fee of $0.82. In total, $5.74 for holding the position for 7 days.
Holding the Position
You hold the position for 7 days and incur the $5.74 financing cost.
Closing the Position
After 7 days, Netflix rises to $330 per share. This means you made $499.80 in unrealized profit. The broker takes a $4.95 exit commission.
Net Profit
After fees:
- Opening fee: $4.50
- Financing fee: $5.74
- Closing fee: $4.95
Your net profit is $484.61, which is a return on your $1,000 investment.
Technical Analysis in CFD Trading
CFDs are mostly short-term trades. Here, technical analysis helps traders time entries and exits by indicating spot trends, reversals, and key price levels quickly.
Chart Patterns
With chart patterns, traders get to know about the instrument price and the potential movements. Here are some popular patterns.
Double tops & bottoms (M & W shapes): Double tops and double bottoms are common reversal chart patterns.
- A double top happens after prices go up. The price hits the same high point twice but can't go higher. It looks like the letter M. So, this pattern often means the price might start going down.
- A double bottom happens after prices fall. The price hits the same low point twice and doesn’t go lower. It forms a W shape. This means the price might go up next.
Head and shoulders: The head and shoulders pattern is a classic reversal setup. It can signal a shift from bullish to bearish trends. It consists of three peaks: the left shoulder, a higher middle peak (the head), and a lower right shoulder.
Note: "Bullish" means you expect prices to go up, while "bearish" means you expect prices to go down.
Key Indicators Used by CFD Traders
Key indicators provide CFD traders with valuable tools to analyze market conditions, identify trends, and make more informed investment decisions. These indicators are often based on historical data and mathematical calculations.
Moving Averages (SMA & EMA): Moving averages are technical indicators that help traders to spot trend directions or identify when to enter or exit.
- Simple Moving Average (SMA) calculates the average closing price of an asset over a set number of periods.
- Exponential Moving Average (EMA) also measures average price but gives more weight to recent data, making it more responsive to price changes.
RSI (Relative Strength Index): The Relative Strength Index (RSI) is another technical analysis, which is a momentum oscillator. This tool measures the speed and change of price movements. It ranges from 0 to 100 to identify overbought or oversold conditions in the market.
- An RSI above 70 typically suggests that the asset is overbought and may be due for a price correction.
- An RSI below 30 indicates the asset is oversold, which could signal a potential upward reversal.
Is CFD Trading Right for You?
Indeed, CFD trading offers several advantages, such as more assets, leverage, and profit from both rising and falling prices. All these attract traders to trade CFDs. But how do you know if CFD is right for you or not?
Before entering CFD trading, ask yourself the following questions to help you make a good decision.
- Are you prepared to take on high risk and complexity? With leverage, you can profit more, but if you lose, this will cost you a hefty amount.
- How will you handle potential risk?
- And how do you set your financial goals?
Also, you need to understand the financial market in-depth and must know how to do technical analysis. For the new traders, having no prior trading knowledge may become tough too.
So, if you are confident in overcoming these challenges, you are welcome to the world of CFD trading. Traders who have experience with prop firms or who have invested before are often more likely to transition into CFD trading.
How to Trade CFDs?
After learning about the advantages and leverage, you may be wondering how to trade CFDs. Is it simple, or are there complicated steps? You only need to choose a CFD broker, open an account, and start trading. That’s all.
Now let's walk through it step by step.
1. Pick a Trusted CFD Broker
Finding a trusted and solid CFD broker is your first step. Only with a good broker are your funds protected and kept in separate accounts. Check for one that is regulated, has a user-friendly interface, has fast execution, and has low spreads. These brokers may offer demo accounts so you can practice before you start real trading.
2. Open Your Account & Deposit Funds
Now it's time to select and open your trading account. This is not complicated and only takes a few minutes. Upload the required details, such as your ID for KYC (Know Your Customer), to get verified. Then, complete the remaining formalities.
3. Choose What to Trade (Stocks, Forex, etc.)
Try to choose an asset you understand better and have more confidence in trading. Because each market behaves differently. For example, forex trades 24/5, while stocks follow market hours.
4. Decide to Go Long (Buy) or Short (Sell)
We already talked about what going long or short is, and this strategy part is really important, as your profit or loss depends on it. For this analysis, is the market technical, fundamental, or both? Then choose which direction you want.
5. Open the Trade & Close When Ready
It's time to enter your trade through the platform. Do not forget to select the trade size, leverage, and direction correctly. Afterwards, keep an eye on the market. You can set alerts or let your stop-loss handle the exits. When the market moves in your favor and hits your target, close the trade.
How to Get Started with CFD Trading? 3 Simple Steps
If getting started with CFD trading is your next goal and you are wondering where to start, here are 3 simple steps.
Step 1: Educate Yourself
For anything new you want to start, including CFD trading, you need to gather as much knowledge as possible. There are very few free resources available. Start from the basics: what CFDs are, how they work, and trading platforms. Do not forget to educate yourself about technical analysis, which will help you to predict price movements.
Most importantly, you need to keep learning and practicing every day. Patience is another key to becoming a good trader.
The best approach is if you follow level by level, so you do not miss anything about CFD.
Step 2: Choose a Reliable CFD Broker
Since you’re putting real money on the line, the second step is choosing the right CFD broker. With a reliable broker, you can rest assured that your funds are safe and also get a better trading experience.
Look for brokers that offer fast order execution, user-friendly platforms, and powerful trading tools. Many also offer perks like sign-up or deposit bonuses. And when you close a winning trade, a good broker ensures your profits are credited to your account quickly and without hassle.
Here, FNmarkets offers 24/7 human support where you can communicate with a real person for any issue you face. Also, the fast execution time and local payment methods are more convenient than what a trader would search for.
Step 3: Develop a Trading Strategy
If you ask which trading you should choose, or which is right. The right trading strategy depends on your style, risk tolerance, market conditions, and personal goals. Choose one that fits all these factors and supports your long-term success.
There are several trading strategies available; among them, these are some common ones:
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Trend Trading: In this strategy, traders follow the direction of market trends. Traders enter long positions in uptrends and short positions in downtrends.
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Position Trading: Position trading is a long-term strategy where traders hold positions for weeks or months. Traders take this decision based on fundamental analysis and long-term market trends.
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Scalping: With this trading method, traders make numerous small trades throughout the day to exploit minor price changes. It's a high-frequency strategy and needs quick decision-making and execution.
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News Trading: News traders capitalize on market volatility following economic news releases or geopolitical events.
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Momentum Trading: This strategy capitalizes on the strength of existing price trends. Traders enter positions when momentum indicators suggest strong price movement, aiming to ride the trend until signs of reversal appear.
Conclusion
CFD trading is ideal for those with lower capital who want access to global market assets and flexible trading options. With proper knowledge of CFDs, technical analysis, and financial markets, traders can choose their preferred markets. Also, potentially profit from both rising and falling prices.
One of the biggest advantages is leverage. This allows you to control a larger position without actually owning the asset. This gives you more market exposure with less upfront capital.
However, since real money is at stake, choosing a trusted and reliable broker is important. Success in CFD trading also requires proper market research, ongoing learning, a strong focus on financial trends, and the patience to wait for the right opportunities.
FAQ
Which Markets Have CFDs?
CFDs are available on many markets, including stocks, forex, commodities, indices, and even cryptocurrencies. You can trade global assets without owning them.
Why Are CFDs Prohibited in the US?
CFDs are banned in the U.S. because they don’t meet the strict rules set by regulators like the SEC and CFTC. These rules are meant to protect retail investors from high-risk products.
Does a Contract for Difference (CFD) Expire?
No, CFDs don’t have an expiry date like options or futures. You can hold a CFD position as long as you want; just keep in mind that overnight fees may apply.
