What is CFD trading?
What is a CFD?
A CFD, or Contract for Difference, is a derivative product that traders can use to speculate on the future direction of a market’s price. You’ll never take ownership of the underlying asset, which means you can take advantage of rising and falling markets. CFDs can be traded on a wide range of over 4000 global markets.
CFD trading explained
Put simply, CFD trading lets you speculate on the price movement of a variety of financial markets such as currencies, stocks, commodities and bonds, regardless of whether prices are rising or falling. Because you are speculating on price movement rather than owning the underlying instrument, you will not pay UK Stamp Duty on any profits.
How does CFD trading work?
When you open a CFD position you select the amount of CFDs you would like to trade and your profit will rise in line with each point the market moves in your favour.
If you think the price of your chosen market will go up, you click buy and your profits will rise in line with any increase in that price.
However, if the price falls, then you will make a loss for every point it moves against you.
For example, if you think the price of oil is going to go up then you could place a buy trade of 5 CFDs at the price of 5325. If the market rose 30 points to 5355 and you closed out your position, you would make a $150 profit, 30 times the 5 contracts that you bought.
However, if the market moves against you and the price of oil falls 30 points to 5295 then you would lose $150.
Why is CFD trading popular with investors?
CFDs are a popular way for investors to actively trade financial markets. This is because CFDs are:
- Tax efficient: You are not required to pay UK Stamp Duty
- Flexible – you can trade on rising as well as falling markets: Trade on falling markets (going short) as well as rising markets (going long)
- Leveraged products: Use a small amount of money to control a much larger value position
- Hedging tools: You can use CFDs to offset any potential loss in value of your physical investments by going short
Trading on falling markets
If you believe a market will fall in value, you can sell a market – known as going short – and make a potential profit from falling prices. This is different from traditional Share dealing where you can only buy, or go long.
The US 500 is trading at 2340. You believe the US 500 will fall as you expect the forthcoming US earning season to disappoint.
You open a sell position of 5 US 500 CFDs at 2340.
The US 500 falls by 65 points to 2275 and you decide to close your trade.
As CFDs allow you to short sell and therefore make a potential profit from falling market prices, they can be used as a tool by investors as ‘insurance’ to offset losses made in their physical portfolios.
For example, if you hold £5,000 of Barclays shares and you concerned that they are due for an imminent sell-off, you can help protect your share portfolio by short selling £5,000 of Barclays CFDs.
Should Barclays share prices fall by 5% in the underlying market, the loss in value of your share portfolio would be offset by a gain in your short sell CFD trade. In this way, you can protect yourself without going through the expense and inconvenience of liquidating your stock holdings.
CFD trading is a margined product
This means you trade by paying just a small fraction of the total value of the contract.
Remember that with leveraged trading, there is a potential for your losses to exceed deposits.
In other words you can put up a small amount of money to control a much larger amount potentially magnifying your return on investment. Remember, however, that your losses will be magnified as well, so you should manage your risk accordingly.
Which CFD markets can I trade on?
Most brokers offer a choice of over 4,000 CFD markets, including:
- Indices such as the UK 100, Wall St and Germany 30
- FX such as GBP/USD, GBP/EUR and JPY/USD currency pairs
- Shares such as Rio Tinto, Amazon and General Electric
- Commodities such as oil, gold and cocoa
- Other markets including bonds, interest rates and options
Is CFD trading right for me?
CFD trading is ideal for investors who want the opportunity to try and make a better return for their money.
However, it contains significant risks to your money and is not suitable for everyone. We strongly suggest trading on a demo account before you try it with your own money.
CFD trading may be ideal for people:
- Looking for short term opportunities: CFDs are typically held open for a few days or weeks, rather than over the longer term
- Who want to make their own decisions on what to invest in: It is not advised to allow anyone to trade for you or trade on your behalf.
- Looking to diversify their portfolio: Most brokers offer over 4,000 global markets to trade on including shares, commodities, FX and indices
- Be as active or passive as they want: You can trade as little or as often as you want
For more insight in understanding, trading and investing, enrol in our free online trading course, which will help guide you through your journey to become a successful trader.