CFD

Disclaimer: The products or services discussed in this article may not be offered by Taurex and may only be listed here for educational purposes.

 

CFD (contract for difference) trading may seem like a more intense form of trading. It’s fast-moving and highly dependent on a volatile financial market. 

In fact, many years ago, CFD trading was the exclusive domain of highly skilled investors. 

Back then, only the sharply dressed City of London or Wall Street professionals would borrow, risk money and speculate on short-term market movements.

However, things have changed thanks to the rise of online trading platforms. CFDs have become popular with retail investors despite being complicated financial instruments.

A critical aspect of your success in CFD trading is working with a time-tested brokerage firm that cares about improving your trading win rate. 

Read on for more information on CFDs and CFD trading.

Understanding CFD (Contract for Differences)

You may think that trading, in any way, shape, or form, is an unnecessary high-risk financial engagement, especially for ordinary individuals. One possible reason for this belief can be the abundance of trading lingo and technical terms.

In the following sections, we’ll help you learn everything you need about CFD trading and how to use CFDs to go long or short on underlying assets.

What Is CFD?

One way to understand CFD is to think of it as a way for two contracting parties, which is you, the trader, and a CFD provider, to speculate and trade on share prices. 

CFD lets you and the broker (the other economic player) exchange an underlying asset’s income and performance for interest payments. You are successful in the trade if the price development matches your speculation.

With CFDs, you can trade on the rising or falling prices of the following liquid assets: 

• Indices
• Stocks and shares
• Foreign exchange or Forex (FX)
• Treasuries
• Commodities

CFDs are financial derivatives, so you never technically own underlying shares, but you get exposure to their price movements.

What Is CFD Trading?

CFD trading is an option that helps people invest and trade in an asset by participating in a contract between themselves and a broker instead of purchasing the asset directly. 

The broker and the trader agree to simulate market conditions and settle their differences when the trade closes. 

CFD trading also allows investors and traders to profit from price changes in the financial markets without directly owning the underlying asset.

Real-World Example of a CFD

Here’s an example of a profitable trade to help you better understand CFD:

A trader wants to buy CFD on a specific ETF (Exchange Traded Fund) that tracks the FTSE 100 Index. The broker has a 5% margin rate, so it takes a 5% down for the trade.

Note: 1 pound = 100 pence

The trader then buys 1000 shares of the ETF for 1600 pence (p) per share for a £16,000 position. In this case, the trader’s initial payment to the broker is only 5% or £800:

Initial payment =Position value margin rate

Initial payment =£16,000 5%

Initial payment =£800

What if the ETF is trading at a selling price of 1,625p per share a few hours later, and the trader decides to close their position? In that case, the price has moved 25 points, and your gross profit is £250.

Sometimes, you need to pay brokers a specific commission depending on your trading account. Higher commissions mean less net profit for traders.

More Examples of CFD Trading

“Going long” means buying a CFD position to profit from a rising market. Example: Going long in CFD trading.

A United Kingdom Company X is trading at 198/200p (where 198 pence is the selling price and 200 pence is the buy price). The spread is 2.

You think that the company’s price will go up, so you open a long position by buying 10,000 CFDs, or ‘units,’ at 200 pence each. Note that the broker’s commission rate is 10%.

Company X has a margin rate of 4%, so you only have to pay 4% of the trade’s total value as position margin. Your position margin will be £800: 

Position value = CFD units buy price

Position value= 10,000 units 200p

Position value =  £20,000

Position margin =£20,000 4%

Position margin =£800

A Profitable Trade

Let’s assume what you thought was correct, and the price increases over the next week to 210/212p. You close your position by selling at 210 pence (the new sell price). 

The price per share increased by 10 pence in your favour, from 200 pence (the opening price) to 210 pence (the closing price). 

To calculate your gross profit, multiply 210 pence by the CFD units you bought, then subtract the product from your position value. In this example, your gross profit is £1000.

In order to get your actual profit, you need to subtract the overall commission from your gross profit.  

Commission (at entry) = Position value commission rate

Commission (at entry) =£20,000 .10% 

Commission (at entry) = £20

Performing the same process for when you close the trade, your commission at exit becomes £20. 

The total commission charge is £41, and your net profit is £959, which means you’ve profited from the trade.

A Losing Trade

On the other hand, let’s say Company X’s share price dropped over the next week to 193/195p. In that case, your first prediction would be wrong.  

If you think the price will continue dropping, you can limit your losses by selling at 193 pence (the new sell price) to close the trade. If you do, you’ll lose £700.  

You must also pay the overall commission charge of £39.3, so your total loss from the trade is £739.3.

Going Long Example

You think Apple shares will perform better and want to open a long CFD position to profit from this possible outcome. 

You buy 100 CFDs on Apple shares for 160p per share for £16,000. If Apple increases to 170p, you make 10p per share and get a £1,000 profit. 

Going Short Example

“Going short” can happen when you think Apple’s price will depreciate, and you want to profit from that scenario. You can open a short CFD position (short-selling) and take advantage of a falling market. 

If you sold 100 CFDs on Apple at $170 per share, which falls to $160 per share after a day or two? In that case, you’ve prevented significant loss and profited $1000.

Margin Trading Example

Another word for margin trading is leverage trading. You don’t have to pay for the total trade size to open and maintain a position.

Here are two margins you must know when trading CFDs:

• Deposit margin: You pay this amount to open a position
• Maintenance margin: You may need to pay for this margin once your trade starts losing and your deposit margin or additional fund can’t cover it.

The margin varies depending on your broker and the asset classes.

How CFDs Work

A CFD usually has three simple steps: 

1. Open a trade with a broker at a specific price.
2. Start trading.
3. Close trade. 

If you’re just beginning to trade by “going long” or buying units, you close your open position with a “sell.” 

If you open a trade with a sell or “short position,” you close it with a buy.

First, you place an initial trade with a CFD provider at a fixed price. This step opens a position you can later close with a reverse trade with the CFD provider at a different price.

The CFD captures the underlying asset’s price difference between the opening and closing trades.

Transacting in CFDs

You can use CFDs to trade many securities and assets, e.g. ETFs. 

These financial instruments are tools to speculate on the price movement of commodity futures contracts, like corn and crude oil.

Futures contracts (FC) are standardised contracts or agreements with terms to buy or sell a specific asset at a fixed price on the expiry date. ‘

You can use CFDs to trade on FC price changes. Please note that CFDs are not FCs.

CFDs don’t have expiry dates with predetermined prices. Instead, they have to buy and sell prices like other securities. 

CFDs are also traded over-the-counter (OTC) using a network of brokers that pull the strings in the market’s supply and demand for CFDs and make prices accordingly. 

Buy

If you think the underlying asset’s price will grow, you should open a long position (buy). You profit from the trade once the price change matches your expectations. 

Sell

If you think there will be a decline in the underlying asset’s price, you can open a short position (sell) and still profit if it matches your prediction.

Why Do People Trade CFDs?

Here are some reasons for trading CFDs:

• Leverage:  CFDs are leveraged products, which means your initial investment is only a percentage of your position’s value
• Hedging: CFDs can be an excellent way to hedge funds since you can offset losses against profits for your capital gains tax (CGT) deficits.
• Flexibility: You can go long or short with CFDs, which means you can trade no matter how the market moves
• Tax benefits: Sometimes, because you never own the underlying asset in CFD trading, you can enjoy specific tax benefits not found in other options.
• Longer hours: With CFDs, you can trade outside regular trading hours. Just remember that the market’s opening price varies from its out-of-hours price.

What Is a CFD Account?

A CFD account allows you to trade on the price movement of many underlying assets through leverage. Leverage means you pay only a fraction of the amount necessary to trade. That fee is called the deposit margin. 

You’ll also need enough in your account to cover any possible losses if trades go against you. This amount is called the maintenance margin.

Before you can trade with them, brokers must know a little about you. They’ll usually ask you to set up a particular account, proving your identity and ability to pay for losses. 

You can also practise trading using a demo account. But you’ll need to add funds to register a CFD trading account before you can trade.

Some brokers require new clients to pass a suitability test. This test usually requires you to answer specific questions to demonstrate your understanding of the risks of margin trading, not just the potential rewards. 

Before and during your trading experience, you should study how leverage and margins work extensively. 

How Can I Get Started Trading CFDs?

Once you’re confident and familiar with the risks, you can register and fund a CFD account, select which market you want to trade in, and thoroughly analyse the asset. 

When you’re ready to trade CFDs, choose your position size and apply your risk management strategy.

How to Trade CFDs

. You can trade CFDs with a reputable broker like Taurex in three simple steps:

1. Open an account  
2. Trade with the advanced and ultra-reliable MetaTrader 5 (MT5), the user-friendly and efficient MetaTrader 4 (MT4), or the intuitive Taurex App.
3. Trade on various CFD instruments in shares and commodities.

Choose the Best Platform

With MetaTrader 5, you can trade with the ultimate confidence using its Straight-Through-Processing (STP) feature. 

You’ll also enjoy tight spreads and exceptional trading conditions.

Steps to Becoming A CFD Trader

Here are some steps you must learn to become a CFD trader: 

Find Out How CFDs Work

CFDs work by simulating the underlying market—you profit (or lose) depending on the share price movement, e.g. you bought five FTSE 100 contracts for 7500. 

An FTSE 100 contract amounts to £10 per point, so for every point of upward movement, you would profit £50. For each point of downward movement, you would lose £50 (five contracts multiplied by £10).

Potential losses and profits will magnify because the trade depends on the entire 7500 positions, not just the margin amount.

Learn How CFD Profit and Loss Works

To calculate the loss or profit from a CFD trade, multiply the trade size of your position (the total number of contracts) by each contract’s value. Then, multiply the outcome by the opening and closing price difference.

Find Out How to Place A CFD Trade

You’re ready to open a position when you’ve picked which market you want to trade in. 

If you think the asset’s price will fall, you’ll sell (go short); if you think it will grow, you’ll buy (go long). 

You can track all your open positions on our trading platform and close them by selecting the ‘close’ button. 

If you opened your position by buying, you could close it by selling the same contracts at the selling price–and vice versa.

Learn About CFD Timeframes

With CFDs, you can trade with CFD futures or spot markets, depending on the market you pick.

Spot trading is best for shorter-term trading because the spot price is the immediate real-time asset price. 

CFD futures or forwards are best for medium- to longer-term trading because they allow you to think about price movements between specific dates.

Know the Costs When Trading CFDs

Most of the time, the spread covers a CFD position’s opening cost, meaning that buy and sell prices will change to reflect the trade costs.

Suppose you maintain a daily CFD position open past the regular cut-off time. In that case, you’ll be charged an overnight funding fee.

This amount covers the cost of keeping your position over the long term since you’re trading on leverage.

CFD Trading Essentials

As you learned, CFD can be quite complicated for beginners. However, with the right resources and help from experts, those who want to trade CFDs might have a better experience.

The following sections discuss CFD trading information you should know.

You Can Go Long or Short With CFDs

In CFD trading, you forecast whether an asset’s price will grow or decline.

Your prediction’s outcome will determine whether you profit or lose. It’s important to note that selling or buying can lead to a loss. Also, ensure that you understand how CFDs work before placing a trade. 

It would also help to implement risk management strategies.  

What Is Short Selling?

Going short, or “short selling,” is a strategy that allows traders to open a position that will grow in value if a financial instrument’s price falls. You can also use this tactic as a hedging tool.

Short-Selling CFDs in a Falling Market

One of the unique advantages you can have in CFD trading is that you can profit from falling markets. 

In CFD, the difference can go in any direction. So you can trade on the possibility of prices rising (a “buy” or “long” order) or falling (a “sell” or “short” order).

If your forecast is right, you can buy back the instrument at a lower price to make a profit. 

If you’re wrong and the value grows, you’ll make a loss. Be careful with this because the loss can exceed your deposits.

CFD Trading Is Leveraged

Leverage in CFD trading allows you to get full market exposure for a less expensive initial deposit (margin). 

In other words, you only have to pay a percentage of the cost of the position to gain exposure to the total value of the trade.

Remember that possible profits and losses can go overboard because they depend on your position’s full size – not just the margin.

For example, if you open a CFD trade with a 20% margin on 500 shares with the share price at 800p a share, you’ll only require £800 to get exposure to a £4000 position.

Note that your losses or profits will depend on the full £4000 value of the position, not the £800 margin.

You’ll Open a Leveraged Position With a Margin

CFD margin requirements can change depending on the market in which you want to take a position – and markets don’t have the same margin rate.

Spread and Commission

With CFD trading, you’ll always deal with two prices based on the underlying instrument’s value: the buy price (offer) and the selling price (bid). 

The offer will always be higher than the existing underlying value, and the bid will always be lower. The difference between these values is called the CFD spread. 

Can You Trade CFDs Without Leverage?

CFDs are leveraged products. If you don’t like placing positions with leverage, then maybe dealing with shares can suit your trading style better.

Note that CFD trading is not spread betting. Spread bets are tax-free leveraged derivatives, while CFDs fall under CGT.

CFDs Behave Like Their Underlying Market

CFD trading typically mimics the underlying market. 

CFD prices largely depend on the underlying market’s movement. Sometimes, asset prices have a spread wrapped around them, while other CFD trades require commission – it all depends on your chosen market.

Advantages of CFDs

CFDs offer traders the benefits and risks of having an asset without actually owning it or taking any physical delivery of the asset.

CFDs are traded on margin, which means the broker allows traders to borrow money to increase the size of the position or use leverage to amplify gains. 

Brokers also require investors to keep fixed account balances before they allow CFD transactions.

CFDs offer higher leverage than traditional trading. The margin requirement for standard leverage in the CFD market can be as low as 2% and as high as 20%. Lower margin requirements mean lower opening prices and greater potential returns for traders.

Fewer regulations surround the CFD market, unlike stock exchanges. Therefore,  CFDs can have lower capital or cash requirements in a brokerage account. 

Since CFDs can mirror real-time market movements, a CFD trader can receive cash revenues, increasing investors’ return on investment (ROI). 

Another advantage of CFDs is that they allow traders to easily take a long or short position. Generally, the CFD market does not have short-selling rules. 

Global Market Access Using One Platform

With a reputable broker’s platform, you can easily access any market you want.

No Shorting Rules or Borrowing Stock

You can sell an instrument any time you want, but there’s no shorting or borrowing cost because you don’t own the underlying asset. 

Some markets have rules that don’t allow shorting, require the investor to borrow the instrument before going short, or have different margin requirements for trading positions. 

Professional Execution With No Fees

CFD brokers give many of the same order types that traditional brokers have: limits, stops, and contingent orders, including “if done” and “ “one cancels the other.” 

Some companies offering guaranteed stops will charge a service fee or recoup costs in another way.

No Day Trading Requirements

Some markets require minimum capital to day trade or restrict the number of day trades you can make within specific accounts. 

The CFD market doesn’t follow these limits, and all CFD investors can day trade if they want. 

Various Trading Opportunities

These variations allow our clients interested in diverse financial markets to trade CFDs as an alternative to exchanges.

Regulated Environment

Find a licensed brokerage firm so you can be confident that you’re trading in a regulated environment. 

You can contact their client support team via email or phone if you have any trading queries.

Fast Execution

STP execution models can help you enjoy flexible access to more than 500 CFD instruments with reliable execution.

Hedging

Highly skilled and veteran traders use hedging as an essential risk management strategy.

A hedge is a risk management practice you can apply to reduce losses. You hedge to secure your profit, especially when the times are uncertain. 

If an investment goes against you, your hedge position will favour you.

CFD hedging helps you protect your current portfolio by allowing you to sell short if you think the price will fall.

Disadvantages of CFDs

Here are some risks to consider before trading on CFDs.

Traders Pay the Spread

Spread costs can sometimes be a burden to CFD traders. You may have to pay the spread when opening or closing a position, trimming potential profits.

Spreads may also decrease winning trades by a small amount compared to underlying assets. 

Weak Industry Regulation

The CFD market has fewer regulations than other industries. 

What Are the Risks?

CFD markets run in full gear and require close monitoring, so investors should know the significant risks when trading CFDs. 

For instance, there are liquidity risks you need to deal with and margins you need to maintain. 

If you can’t cover reductions in value, then your CFD provider can close your position, and you’ll have to pay the loss no matter what happens to the underlying asset.

The Costs of CFDs and CFD Trading

Below are some examples to help you understand CFD trading costs.

Opening a Share CFD Trade

Let’s say the commission rate for a specific market is 0.1%.

You “buy” 10,000 shares from UK Company Y at a price of 500p a share. You’ll  incur a minimum commission charge of £500 to enter the trade:

Position value = 10,000 (units) 500p (opening price)

Position value = £50,000

Commission charge = £50,000 0.1%

Commission charge = £500

Please note: CFD trades usually incur a commission charge when opening and closing the position. So, you may apply the calculation above when closing a trade; the only difference is that you use the closing price instead of the entry price.

What Are Margin and Leverage?

“Leverage” or leveraged products allow investors to deposit a percentage of the total price of opening a trade. This trading option is called margin trading or “margin requirement.”

Profit and Loss

You can estimate your profits and losses easily: just calculate the product between your units and the price difference. 

You can use this formula to determine your profit-to-loss ratio (P&L).

P&L = number of CFDs x (closing price – opening price)

CFD Trading Strategies

Here are some CFD strategies you can implement for a better CFD trading experience.

Advanced Strategies for Risk Management Using CFDs

CFD risk management is one of the important factors to consider and apply in your trading practice.

CFDs are complicated financial instruments, and trading them involves high risk. Trade values can rise and fall quickly, so you may get losses if the market moves against your predictions.  

Once you’ve registered an account and designed a trading plan, determine how much you’re willing to risk to devise an appropriate CFD risk management plan. 

If you’re risk-averse, you should be after opportunities with lower risk-to-reward (R-R) ratios. For example, asset classes with higher volatility must form a small proportion of your portfolio if you’re looking for gradual and steady growth. 

Diversifying across all asset classes is wise to increase the probability of profitable trading opportunities and lessen overall risk.

Stops-Loss and Take-Profit

You should also set up limit orders when trading CFDs. These commands automatically close out a position at a specific profit, so you don’t have to watch the market 24/7. 

Take-profit orders can help reduce the possibility of you maintaining a winning trade for too long only to see the price fall again. 

CFD markets are highly volatile, so trade with your head, not your heart.

You can also set up stop-loss orders to lower CFD risks and minimise your potential losses. 

A stop-loss is a point at which your position will automatically close out if the asset’s price drops below a specific amount. 

Stops and limits are important risk management techniques, and we recommend using them.

Negative Balance Protection and Margin Closeout

Traders should meet the maintenance margin required to keep their positions open. When trading, you usually keep this minimum fund value to cover any credit risk.

The margin account fund acts as collateral for credit. Reputable brokers give margin calls and notify you if your market exposure is about to exceed the maintenance margin requirement. 

During margin calls, you’ll have the option to close some of your positions or top up your balance.

If you don’t act and the closeout level arrives, our trading platform automatically closes your positions. 

With negative balance protection, you can be confident that your account balance never drops below zero. 

If a market movement suddenly goes against you, our platform can help reduce the possible risk.

Hedging Your Physical Portfolio With CFD Trading

If you have already invested in your current portfolio of physical shares with a broker, and you think they will depreciate over the short term,  you can implement a CFD hedging strategy​.   

By short-selling the shares amounting to your CFDs, you can profit from the short-term decline to offset any loss from your current portfolio.

Then, you can close out your CFD trade to secure your profit as the short-term downtrend ends and the value of your physical shares starts to rise again.

Key Takeaways

Here are some takeaways from our CFD discussion:

• CFDs are paper contracts. You don’t own the underlying asset when you “buy” a share.
• CFD trading allows you to gear up because you only have to pay a small percentage of the underlying value of the investment.
• You can go short with CFDs anytime you want.
• Because you’re taking a loan for most of the cost of the share, your ROI is magnified if the shares go up. The same goes for losses.

FAQs

1. Is trading CFDs safe?

All financial investments involve risk, and CFDs are no different. 

2. How much should you invest?

CFDs democratise trading by giving you low entry prices. 

3. How do CFD providers make money?

CFD providers profit primarily in two ways: commission charges and spreads.

4. How do I use CFDs for hedging?

You can open a CFD position if you think your other trading positions are beginning to incur a loss. 

5.  Is CFD trading tax-free? How are CFDs taxed?

We don’t give tax advice. But generally, CFDs in the U.K. are free from stamp duty but subject to CGTs. 

We strongly recommend getting financial, legal, and tax counsel before starting with CFDs. 

6. What is the difference between CFDs and futures?

Futures require you to trade in the expected future price of an instrument. They specify a fixed price and date for this transaction, unlike CFDs, 

7. Does a CFD expire? How long can you hold CFD contracts? What is the contract length of CFDs?

CFDs don’t have expiry dates in most markets, so you can maintain your position for as long as you want. 

8. What instruments can I trade? Which assets can I trade as CFDs? 

Brokers offer various CFD trading options, including FX, indices, commodities, metals, currencies, and stocks.

9.  Are there assets that are only for CFD trading?

Yes. Some assets, like indices, are not physical, so you can’t own them. You can only trade them as CFDs.

10. What are fractional shares?

Fractional shares are the percentage you need to pay to open a CFD position.

11. Is CFD trading legal?

The legality of CFD trading varies depending on each country’s policies. Still, many countries, like the U.K., allow CFDs, provided brokers observe strict regulations. 

It’s important to trade with regulated brokers, like Taurex. 

Taurex is regulated by the institutions listed below:

• United Kingdom: Financial Conduct Authority (FCA)
• Seychelles: Financial Services Authority (FSA)
• United Arab Emirates: Dubai Financial Services Authority (DFSA)
• Sierra Leone: Central Bank of Sierra Leone

12. Is CFD trading good for beginners?

Pros and beginners can join CFD trading. But it’s not a necessary investment for all investors. 

You should understand the risks first before trading CFDs.

13. Can you lose more than you invest in CFDs?

CFDs are leveraged products. They’re double-edged swords, meaning you’ll profit or lose at a magnified level, depending on the market’s movement.

That’s why it’s important that you trade with brokerage firms that value safety and success equally. 

Reference

1. Contracts for Difference https://www.gov.uk/government/publications/contracts-for-difference/contract-for-difference