What Is a CFD?

The Contract for Difference is a financial derivative. A CFD is a financial contract and pays the difference in price between opening and closing the trade. CFDs are popular for trading the forex and commodities markets over short-term. In today's guide by PFI, we will be going into details regarding CFD – everything you need to know.

This financial asset has recently become very popular among traders and offers a unique way of making money without having to own the underlying asset. It is a futuristic concept that is pretty simple to understand. Everything can be complicated to learn at first. That does not mean that you can’t do it profitably. If you are willing to be disciplined and work hard, you too can make money by trading CFDs.

This method of trading involves creating equity through price margins. When there is a price change, a trader will look to make a profit from this. It is straightforward to understand. If you predict that the price of a commodity is going to increase soon, then you buy or go long.

When it does increase, you sell it, the difference in its price becomes equity. I.e. It is the profit you made. In this case, you are not physically buying an asset. You are instead buying the price difference. The price difference can be positive or negative, and this is added to your balance. If the difference is negative, it is deducted from your trading account balance. If positive, then you will see your balance increase.

You agree with your broker when you sign up to the trading platform. That is all that is necessary to facilitate this exchange. It is this simply because the financial authorities do not very strongly regulate CFDs. In trading CFDs, you will have a significant amount of flexibility in how you handle it. That is one of the reasons it is desirable to investors.

Pros of CFD trading

There are some benefits to trading through CFDs. Let's explore some of them.

  • Leverage – When regular trading, you will find that your leverage is not as high as it is with CFDs. The leverage that is guaranteed in this market is set to increase to over 50%. It is well within the laws that regulate financial markets. Having greater access to leverage means that you can achieve much higher profits than you would otherwise manage. Usually, you can’t make money you don’t have, but CFDs allow that. You should also consider the risk involved. Having more significant capital at your disposal can lead to greater losses in trading. You should only trade when you have managed to obtain consistent results using your trading strategy.
  • International markets available – CFDs are available globally in many financial markets. The broker you choose will most likely provide you with uninterrupted access to these markets. They operate non-stop throughout the day and night. There are over 4000 markets that you can select from. The sheer volume of markets that you can trade on should tell you something. That there is high volatility. That is where CFD traders look to make their profits.
  • Small Capital Requirements – This is the reason that this market is well sought after by traders. It has very few rules. You can join with relatively small capital compared to the other financial assets on the market. You are also free to trade as your heart commands. Your strategy is not bound only to day trading but can be designed as you like. The freedom here can be both an advantage and a disadvantage. There is little doubt that beginner traders may prefer structure in their trading and will look for more simple markets. If you, however, want full control over how you trade then CFDs will work well for you.
  • Open Playing Field – When trading CFDs, you have the choice. The rules do not try to stifle anyone into doing what they do not want to do. You can short the financial asset when you see fit. There will be no charges if you do so. You may be wondering why. It is because when trading CFDs, you are only trading the difference in a financial assets price. You are not trading the actual asset itself. That is the reason why there is so much flexibility in how you can trade it.
  • Flexibility – The flexibility around trading this asset has provided more potential for efficiency. Brokers who trade CFD financial assets can offer more than the conventional stop loss and take profit protocols. They offer contingencies to their customers to sweeten the deal. These come in the form of if statements. I.e. cancel if x action takes place. This benefit is not found among other financial assets.

Cons

CFD trading comes with some disadvantages. We'll explore some disadvantages below.

  • Regulation – The CFD industry is not regulated as a whole. That is not to say there aren't good brokers. Choosing the right CFD broker is important. You must ensure that you do an extensive check on how the broker you choose does business. That is to ensure the safety of your investment. It is not to say that there are not a lot of CFD brokers who are worth every dollar. It is just to say that you should do your due diligence and not just take anyone’s word for it.
  • Risks – This point should be well understood before you begin exploring the world of trading CFDs. Trading CFDs is not allowed in the United States. That is because it is not industry regulated. What does this mean for those of you who can trade it? It is high-risk. It is a very high pace market to be in. Any lapse in concentration can prove to be costly. That is because of the adequate liquidity and risk margins you need to manage. You have access to the different contingent features, but even those can let you down. You need to be quite experienced before you decide to trade.

Risks

Having high leverage is a fast way for one to incur high losses. Trading with money you don’t technically own can bring drawbacks. The market is known to be consistently volatile with its price movements. There can be slow days. There can be days when profitable price movements are not so frequent. On these days, the money you leverage can work against you. At this point, the broker may close your position, and you will lose. This is called a margin call. You will also need to be on the lookout for any delays in your bid being processed. There may be many trades happening at one time. It may lead to an inability to process trades as fast as you would like them to be. At this moment you will lose if there is a spike in the direction you were not expecting.

How does it work?

When trading this financial derivative, you need to forecast the direction of an assets price. This is going to be either higher or lower. Instead of saying higher or lower, many traders also use the terms ‘long’ and ‘short’ respectively. When trading CFDs, you are only dealing with the price.

This means that you will not be taking ownership of any underlying assets in this deal. You are rather looking to benefit off the price movements as they happen. You will need to invest a small amount of capital on each trade you make.

The term margin will become familiar to you. For example, when you wish to trade something worth $1, then you may be required first to put in 50c. If you are successful in forecasting the direction of the product, then you will make profits.

It means that you are receiving the difference between the price you initially bought for and the now new price of the CFD. This will also work against you if you are unsuccessful in predicting the new price. If you are successful, then you will have a positive difference between the two prices. If you are not successful, then the negative balance will be incurred by yourself.

Is it trading safe?

The answer to this question is yes. Foremost, like with every single financial asset you wish to trade, it depends on your broker. You need a broker who has managed to obtain its reputation over the years. You will try to avoid any brokers that offer you things that are too good to be true. When money is involved, you should be twice as careful than normal.

With the right broker then trading CFDs is perfectly safe. What do we mean by safe? We mean that if you trade well and make profits, you will have access to them with no plot twists. By safe, we do not mean that they are easy ways to make money. Therefore, how safe they are is entirely up to how well you do your research. It is also how well you design your CFD trading strategy.

Some restrictions apply to citizens from different countries. It is illegal in America, as we mentioned earlier. This is about the only country that I know of which does not permit its citizens to trade CFDs.

This is for their own risk as the government feels it is not well regulated. Otherwise, for citizens of other countries, it is 100% legal.

CFDs are offered by the same brokers you would go to for almost any financial asset. This means that if you already use a certain broker to trade other financial assets, you can use them for trading CFDs. That is if you trust them. I say this because it is well known that CFDs are traded on thousands of platforms. This should give you a little bit of comfort in knowing it is a well traded financial asset.

How long can you hold positions open?

As we have mentioned earlier CFDs are a very flexible financial asset to trade. They allow you to hold a CFD for as long as you want to. The only way the position may be closed is if the broker does that. Do note that overnight funding fees might apply.

Trading Platforms

CFD trading platforms will allow you to access the financial markets. There are many brokers available. You need to be able to choose the right one. This will be the trading platform you access the markets with.

When looking for the right trading platform, you need to know how well they cater to beginners. You need to look at the reviews on google to ensure that it is reliable, safe and tested by others. You need to be aware of the commission and fees charged on each trade. Another important factor to considers is the minimum deposit. How much capital do you need to start trading with them.

You need to ensure that the platform is user friendly and easy to understand. If it is not, then you may struggle. Remember that a complicated platform does not offer a greater chance of making money than a simple looking one. Once you have chosen a platform to try to sign up for a demo account. With a demo account you can try the trading platform, before trading with real money.

You should also try to put in a small amount of money and withdraw it. This allows you to rest easy knowing your money is accessible at any time you need it.

Trading Apps

Finding a good trading app enables traders to open and close positions on the go. The best ones also allow traders to research CFDs, track performance and portfolio and offer other tools and features.

Best Trading Apps for CFDs

  1. Plus500 – Great CFD Trading App
  2. eToro – Best For Copy Trading CFDs
  3. AvaTrade – Best User Interface (AvaTradeGo)
  4. IQ Option – Award Winning Platform
  5. Interactive Brokers – Great for Advanced Traders

What CFD products can you trade?

CFDs are not necessarily a financial asset in the way you would think of it. It is not like a commodity. It is more of a tool that provides traders the opportunity to trade. It allows traders to make profits off leverage and margins on the price movements on the asset you have chosen. This means that you are not technically involved with the market. Not being directly involved with the market allows you to trade when you want.

You can trade CFDs on the following instruments:

  • Stocks
  • Forex
  • Cryptocurrencies
  • Commodities
  • Indices
  • ETFs

Learning how to trade CFD

To become successful at anything, you need to put in hard work. Trading CFDs is the same. You would not trust your company to someone who was unqualified, would you? Think of CFD trading as your business, and you need to be qualified enough to run it successfully.

To learn how to trade CFDs, you can try the following.

  • Mentors – Due to the complex nature of trading, it is always advisable to get a walk-through from someone experienced. When you first open a trading platform, everything seems confusing. The graphs, patterns, technical analysis tools and buttons can be confusing for the untrained eye. To give you some direction, it would be good to find someone you know and trust to show you the ropes. This will provide you with a less frustrating path to understanding CFD trading. There are seminars that you can find by self-proclaimed trading gurus online, but it's best to avoid these if you can. Unless this person has been personally recommended by someone you know, avoid them. These courses and inside secrets are often scams. A Lot of information is available on the internet for free.
  • Online Courses – There are courses for anything you can think of on the internet. If you are thinking of CFD trading, then this is an excellent way to go. If you work full-time and don't have the time to learn trading, then online course could be the solution. You can find some free courses offered by brokers to encourage you to sign with them. You can also pay for trading courses from reputable establishments such as universities and technical colleges.
  • Trading Books – The tried and tested method of learning through books. There are books for everything, so these should not be hard to find. When starting, we recommend that you begin with a book for beginners. If you are planning to do this long-term, you need to know the basics. There is no need to rush. If you rush into something much more complicated, you may quickly become disinterested in trading CFDs. Keep it simple!
  • Demo Account – This is not an option but a necessity. It will be crucial to tie together the theory. The demo trading account is where it all comes together. A demo account is an account that mimics the real-world financial markets almost 100%. It allows you to test out strategies. It also allows you to get a feel for the platform, before investing real money. It does not require any money and all money used to trade on it is virtual. If you had made that trade with a real money account, then you would have made profits in real life too. The theory of trading is very complicated when not used in conjunction with the demo account.

Tools

Tools can be useful for trading. It is a very technical discipline. You need to make use of tools to have the highest chance of success.

  • Currency Converter Tool – This will allow getting real-time exchange prices for the CFDs you are trading. You need to be able to make decisions as you go, and having real-time currency exchange rates at your disposal will help you make decisions faster. It is a handy tool that saves you from having to manually calculate the value of things in a currency you can understand.
  • Pip Value Calculator – Once you have already opened a position in the market, you will need to be continuously updated as to how much your investments are currently worth in the currency you are trading in. You will come to find for yourself that the currency changes may be confusing. That is why this tool exists to help you keep on top of things.
  • Swap Rates Calculator – There may come a time when you wish to hold a position throughout the night. When you do this, you may be charged what is called a swap rate. To calculate this, you can use this tool. The manual process can be time-consuming and a little confusing for beginners.
  • Margin Percentage Calculator – Earlier, we discussed margin and leverage. So, if you have thought the calculation was complicated, then this may ease your mind. There is a margin percentage calculator that is handy and can be used at any time. Therefore, your margin will be calculated and presented to you before you attempt to purchase a trade.

History

This financial derivative finds its roots in the 1990s. It was created to trade price margins as though they were equity. It was launched on the London Stock Exchange.

Taxes on CFDs

There is a lot of leniency around the way CFDs are taxed, which makes them popular among traders. There is no Stamp Duty to be paid when trading this financial asset. If you manage to make profits that are based on your spread, then you are not expected to pay Capital Gains Tax. It is considered gambling by some of the authorities. You may be expected to pay Capital Gains Tax if you go over your quota for the year.

Strategies

There are many CFD trading strategies. We cover some popular ones below. Every successful trader develops his own strategy over time.

  • Range trading
  • Trend trading
  • News trading
  • Hedging
  • Contrarian investing
  • Breakouts
  • Swing trading

Costs

The main cost associated with CFD trading is charged by your broker. There is often a commission on every trade that is executed by the trader. The charge usually is so small that you wouldn’t notice it. It depends on the broker how much their fees are. Expect costs at the beginning and end of a trade in the range of 0.1 % of the investment.

FAQ

Here are some of the frequently asked questions about CFD trading.

Do CFDs pay Dividends?

They do not pay dividends. You make profits from trade, and these profits are then accessible for you to withdraw. They are the same as trading any other financial asset on your broker’s platform.

Can you get rich by trading them?

Yes, some traders became rich by trading CFDs. It is not easy and requires severe discipline and experience.

How to start with $100?

You can start trading with $100 if you are willing to use leverage. Bear in mind that leverage carries more risk and can end up wiping out all your funds. If you are patient, you can make small profits time and time again. Over time you will have enough to make bigger trades. You need to sign up with a broker that has a minimum deposit of $100 or less.

Why do most traders lose money?

There are studies on why traders lose money. The fact remains the same, a high percentage of traders lose money for all sorts of reasons. Poor money management, strategy, and timing are common reasons.

Why are CFDs banned in the US?

CFDs have been banned in the US because it is not regulated enough to meet their financial laws. The US regulators consider CFDs too risky for their investors to make. Should something go wrong, the United States will not be able to help them.

Can you lose more than you invest?

No. Your investment is limited to the amount of money you agreed to risk on a trade. If you lose it all, then you cannot be liable for any more money.

What happens when CFDs expire?

When one expires, the position is closed, and you cannot make any further trades.

How long can you hold one open?

You can hold CFD positions open for as long as you want to. Most brokers charge overnight funding fees.

What are spreads?

Spreads are the difference between the buy price and the selling price for a financial asset.