CFD trading is a way to buy and sell CFD instruments with the goal of making money. But what are CFDs and how do you trade them?
What are CFDs (contracts for difference)
A contract for difference (CFD) is a financial instrument that allows you to speculate on price movements. A CFD is a derivative, meaning its value is derived from another asset, usually a share or index.
Because CFDs are leveraged products – meaning you gain exposure to larger positions without having to commit the full amount of capital upfront – you only need to put down an initial margin deposit calculated as a percentage of the full value of your position. This allows you to access greater exposure for significantly less capital outlay than if you bought or sold the underlying asset outright.
Definition of CFD trading
Let’s start at the beginning. In simple terms, CFD trading is a speculative trading method that allows you to invest in a wide range of financial markets without taking ownership of the underlying asset.
What do we mean by this? Instead of purchasing and owning shares, you can use CFDs to speculate on the price movement of stocks (or any other market). This means no physical share certificates, expensive brokerage fees and no hassle.
CFD trading lets you trade in rising or falling markets, on your choice of thousands of global markets. You can speculate on the price movement of stocks, forex, indices, commodities and more – all from one platform.
Advantages of CFD trading
- Leverage is the main advantage of CFDs. With leverage, you can control a larger contract size with a smaller deposit — effectively allowing you to take bigger positions and magnify your potential profits.
- You can diversify your portfolio with CFD trading because you don’t need to already own an underlying asset in order to trade it. If a stock is too expensive for you to buy shares at its current price, but you still want exposure, you can use CFDs to gain exposure to the stock (without owning any shares). This means that instead of investing in one or two assets at a time, it’s possible for you to invest in multiple assets simultaneously — which can help reduce risk by spreading investment across different asset classes.
- Short selling is another benefit of CFD trading. By taking a short position on an asset, it’s possible for you to profit if the price goes down — without having access to margin or borrowing money from your broker. Short selling also allows investors who think an asset may be overvalued in the short term to profit from its decreased value before buying more at a later date when they believe the price has fallen enough.
How does CFD trading work?
CFDs are a contract between the buyer and seller, which stipulates that the exchange between them will be the difference between the opening and closing price of a contract. The CFD gives you exposure to a particular underlying asset or market. You can buy or sell a CFD depending on whether you think its price will rise (go “long”) or fall (go “short”).
One important thing: CFDs are traded on margin. This means you only need to deposit a small percentage of your exposure to enter into an open trade.
And another: It’s important to note that when trading CFDs, you do not own the underlying asset on which your contract is based.
What is this concept of CFD leverage?
CFD leverage is the amount of money you borrow from your CFD provider to trade a CFD. Leverage is expressed as a ratio. For example, if you have $500 in your account, and the leverage for the market is 1:100, then you’ll be able to buy or sell $50,000 worth of contracts at an entry price of your choice.
There are two types of leverage: fixed and variable. Fixed leverage gives you a set amount of borrowing power for each position that you enter. Variable leverage allows you to select your own leverage level. As the name implies, variable leverage can change based on the size of your position, so it’s important to understand how your CFD provider calculates variable leverage before trading.
Is CFD trading risky?
CFD trading carries a high level of risk since leverage can work both to your advantage and disadvantage. As a result, CFDs may not be suitable for all investors because you may lose all your invested capital. You should not risk more than you are prepared to lose. Before deciding to trade, you need to ensure that you understand the risks involved taking into account your investment objectives and level of experience. Past performance of the underlying instrument in question is not indicative of future results.
CFD Margin explained
So, what is CFD margin? CFD margin is the minimum amount of money you must deposit in your trading account to open and maintain a position. Why do you need it?
When you trade CFDs, we are not actually buying or selling any underlying instruments; instead, we are speculating on the price of that instrument. Because trades are leveraged, losses can exceed initial investments if the price moves against you significantly. Consequently, all providers require a minimum amount of money to be deposited in your account before you can place any trades. This is known as your margin requirement.
If your positions move against you and your margin level reaches 100%, a broker will close some or all open positions to protect you from further losses. This is known as a “margin call.” However, this is oftentimes not enough to prevent you from incurring debt.
The reason behind the cfd disclaimer
The CFD warning is present because CFDs are very high risk and it’s important for traders to fully understand the risks involved.
CFDs are a leveraged product, which means you can gain a large exposure to an asset at a relatively small cost. This can be good if you use your leverage wisely, but it can also expose you to significant losses if the market moves against your position.
Investing Guides strongly recommends you familiarize yourself with CFD calculators and further in-depth research should you still wish to trade contracts for difference. Otherwise, it might be safer to investigate stock and ETF investing instead.