The CFD Trading Guide | What Are Contracts for Difference?

May 08, 2021 10:00 UTC
Reading time: 16 minutes

Contracts for Difference, or CFDs, are a type of financial derivative product which allow traders to speculate on the price of an asset. CFD trading has low barriers for entry in terms of cost and they are available to trade online. However, they can be a complicated instrument and before getting started it is a good idea to properly educate yourself on how to trade CFDs.

Never fear! In this article, we will explain in depth what Contracts for Difference are, how they work, the benefits and risks of CFD trading, how to trade CFDs and much more! 

What Are CFDs? 

So, what are CFDs? A Contract for Difference (CFD) represents an agreement between two parties to exchange the difference in the value of an asset from the time at which the contract is opened, to when it is closed. 

To better understand how to trade CFDs, a good place to start is by looking at traditional investing.

If you wanted to invest in a public company, you may choose to buy shares in that company. Similarly, if you wanted to invest in gold or oil, you could buy a bar of gold or a barrel of oil. Then you would wait for the price of your shares, gold or oil to hopefully increase, enabling you to sell the asset at a higher price and thus make a profit. 

CFD trading works in a similar way - you open a trade on an asset at a certain price, wait for the price to either increase or decrease and then close the trade for a profit or loss on the difference. 

One of the biggest differences between trading CFDs and traditional investing is that, with Contracts for Difference, you never take ownership of the underlying asset. Instead, a CFD mirrors the price of the underlying asset and, rather than buying that asset, you merely speculate on how its price might change.

How Do CFDs Work? 

To answer this question, it is best to look at an example. Let’s say you wanted to trade CFDs on gold.

If you believed the price of gold might rise, you could open a buy, or long, trade in your CFD trading platform. If you opened the CFD trade when gold was priced at $1,500, and then closed the trade when gold hit $1,525, you would make a profit of $25 (not accounting for any trading costs). 

On the other hand, if you thought the price of gold was going to fall, you could open a sell, or short, trade in your CFD trading platform. If you opened the CFD trade when gold was priced at $1,500, and then closed the trade at $1,450, you would make a profit of $50 (again, not accounting for any applicable costs of trading).

Trade on a Risk-Free Demo Account

A demo account from Admirals is the perfect place for a beginner trader to learn how to trade CFDs or for an experienced trader to perfect their strategy! A demo account allows you to practise CFD trading in real-market conditions with virtual currency before risking your capital on the live markets. Click the banner below to open a free demo account today: 

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What Are the Benefits of CFD Trading? 

Whilst there are plenty of CFD brokers who would be eager to provide you with a long list of benefits, sometimes it can be hard to know what to believe - is everything that they are saying true or is it just another sales pitch? Keep reading for a balanced overview of the general benefits of CFD trading, after which we will look at some of the risks involved. 

Leverage 

One of the biggest benefits of CFD trading is the use of leverage. CFD leverage allows you to access a larger portion of the market with a smaller deposit.

The amount of CFD leverage you will have access to depends on the instrument you are trading, your local regulator and your broker. For professional traders, you may be able to obtain leverage of up to 1:500. For retail traders, some instruments will allow leverage of up to 1:30. 

So, if you have $1,000 in your account balance, and available leverage of 1:30, you can access $30 for every $1 in your account.

This means that, with a relatively small deposit, you can still make the same profits (and losses) you would make in traditional investing. The difference is that the return on your initial investment is much higher. However, CFD leverage must be used with caution, as potential losses are magnified to the same extent as potential profits. 

Below is an example of how CFD leverage works, continuing with our previous example of gold: 

  Gold CFD trade  Traditional investment 
Leverage 1:20 N/A
Your deposit  $300  $1,500 
Long gold trade opens at $1,500, closes to $1,525  You make $25, or 8.33%  You make $25, or 1.67% 
Long gold trade opens at $1,500, closes to $1,450  You lose $50, or 16.67%  You lose $50, or 3.33% 

Trade Long and Short 

One of the downsides of traditional investing is that you only make a profit when the markets are going up. However, trading CFDs allow you to trade both long and short, meaning you can profit in both rising and falling markets. 

In a long CFD trade, the trader thinks that the value of an asset will increase. Therefore, they open a 'buy' trade at a lower price and then, hopefully, sell (or close the trade) at a higher price for a profit. If the market turns and the price decreases, however, the result will be a loss. 

Depicted: Admirals MetaTrader 5 - USDJPY Daily Chart. Date Range: 8 June 2021 - 17 December 2021. Date Captured: 17 December 2021. Past performance is not a reliable indicator of future results.

 

In a short CFD trade, the trader thinks an asset's price will decrease. Therefore, the trader opens a 'sell' trade, and will close it at a lower price, making a profit on the difference. Like in a long trade, if the asset's price moves in the opposite direction to what you expected, the trade would end in a loss. 

Depicted: Admirals MetaTrader 5 - GBPUSD Daily Chart. Date Range: 8 June 2021 - 17 December 2021. Date Captured: 17 December 2021. Past performance is not a reliable indicator of future results.

 

With the ability to trade both long and short, Contracts for Difference allow traders to find opportunities in any market. 

Wide Range of Tradable Markets 

Because CFDs are derivatives of other assets, they can be created to represent virtually any market. In fact, many CFD brokers (like Admirals) give traders access to thousands of financial markets through a single CFD trading platform. 

Just some of the markets available for CFD trading include:

Trading Hours 

As we have already covered, CFDs reflect the prices of an underlying asset; they also reflect the trading hours of those assets. During the week, there is always something available to trade, no matter what the time of day is.

Here are the trading hours for some popular CFDs: 

  • Forex CFDs: 24 hours a day, 5 days a week 
  • Index CFDs: 24 hours a day, 5 days a week 
  • Share CFDs: Available for trading during the hours of the relevant stock exchange 
  • Commodity CFDs: 24 hours a day, 5 days a week 

Across a week as a whole, trading is available on Forex, commodities and indices from midnight on Sunday evening until 11 pm on Friday (London time). 

Short-Term Trading 

CFDs are also a useful tool for short-term trading, allowing you to capitalise on short-term price movements in the stock, index or commodity markets, without a large initial investment. 

If you are thinking about short-term trading, or even scalping, it is important to choose a CFD broker that offers fast execution speeds for their trades. A good broker should be able to execute trades in less than a second, which is essential in fast-moving markets. 

Expiration Dates 

Another benefit of CFD trading, is that most CFD trades do not expire. Whilst some markets may have expiry dates built into the trade, CFDs do not. Instead, you can close your CFD positions at any time you wish. 

The benefit of this is that you can make very long-term trades without worrying about them being closed before you are ready due to hitting an expiration date. However, there are times when a trade may be closed on your behalf, such as, for example, if there are not enough funds left in your account. 

Of course, there are some exceptions, such as CFDs on commodity futures, which do have an expiration date. However, you do not have to wait until the expiry date to exit your CFD trade. 

Costs of Trading 

Finally, the cost of trading CFDs is often lower than other forms of investments. We have already discussed traditional investments, where you need to pay the full value of the asset to invest. With lower margin requirements, CFDs have a lower cost of entry. 

Additionally, CFDs have no opening or closing fees. Instead, most CFD brokers earn the majority of their income on what is known as the 'spread'. If you look at any instrument in your CFD trading platform, you will see there are two prices quoted - one to buy the CFD and another to sell. These are known as the bid (buy) and ask (sell) prices and the difference between them is the spread

Therefore, when you open a trade, the price of the asset needs to cross the spread before the trade becomes profitable. The spread itself goes to the broker. 

Some CFD brokers might also charge commission charges. Additionally, if you keep a CFD trade open overnight, you might be charged an interest fee, known as the 'swap'. You can calculate the fees on a potential trade by using our free trading calculator.

Tax may also be something to consider but will vary depending on your individual circumstance and geographical location. For example, in the UK, investors will have to pay Capital Gains Tax (CGT) if above your threshold for the year, however, no stamp duty is payable. It is always best to consult a tax specialist for further details.

What Are the Risks Associated With CFDs? 

As with every investment, there are risks involved in CFD trading. CFDs are complex products, which carry a high level of risk, so it is important to do your research thoroughly before you start using them. 

The primary risk of any type of trading is market risk. If the market moves in the direction you traded, you will make money, if it moves against you, you will lose money.

However, because CFDs benefit from leverage, these losses can be more extreme when compared to your initial investment, which is why it is important to always use leverage with care.

In volatile markets, this could lead to your balance dropping below 0, known as a negative account balance. With this in mind, it is very important to choose a CFD broker that offers a negative balance protection policy.  

How to Trade CFDs

Now that we have covered the background on CFDs, their benefits and risks, you are probably wondering how to trade CFDs online. There are a few steps involved, but we have broken it down into a simple guide to help you on your way! Here's how to trade CFDs online.

1) Create a Trading Account 

Firstly, you need to open an account with a reputable CFD broker. This could be a live account, where you deposit money and use that to trade on the financial markets, or it could be a demo account, which allows you to get to know the software and practice your skills with virtual currency. 

If you need help choosing a CFD broker, check out our guide below:  

How to Find the Best CFD & Forex Brokers

2) Download a CFD Trading Platform 

Picking the best CFD trading platform is one of the first things to consider when trading CFDs online. In fact, it is also a factor to consider when choosing a CFD broker. 

You don't need a CFD trading platform specifically designed for trading only CFDs. If your broker offers CFDs then you'll be able to trade them on the platform they work with. 

Admirals uses the most popular platforms in the trading world, MetaTrader 4 and MetaTrader 5, which are designed specifically for trading both CFDs and Forex.

The MetaTrader platforms have advanced charting features, technical indicators and a large support community. These platforms are also some of the most stable, user-friendly and accessible on the market, making them excellent CFD trading platforms. In order to download MetaTrader 5 for free, click the banner below:

The World's Premier Multi Asset Platform

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3) Choose Your Trading Methodology 

Now that you have your CFD trading platform and all of the foundations in place, the next thing to think about when learning how to trade CFDs is your trading methodology. With so many potential trades available across so many markets, it is important to have a plan of attack. 

Here are some of the elements to consider in your trading approach: 

  • Routine: When will you look at the markets each day?
  • Trading Style: What kind of trader are you? Day trader, scalper, swing trader or will you manage long-term trades? 
  • Markets: Which markets will you focus on? Shares, Forex, commodities? 
  • Strategy: How will you make trading decisions to buy, sell or exit a position at a profit or loss? 
  • Risk management: What position size, stop losses and take profits will you set to limit your risk? 
  • Support: How often can you educate yourself by reading the library of educational articles and tutorials on offer to further develop your skills? 

4) Make Your First Trade! 

The most exciting step in learning how to trade CFDs is making your first trade on a live or demo account. Just follow these steps: 

  • Open your MetaTrader trading platform and log into your trading account. 
  • Go to the 'Market Watch' window on the left-hand side of the screen
  • Double click on the instrument of your choice. 
  • Choose your position size
  • Click on 'buy' or 'sell' depending on what you think will happen to the asset’s price 
  • Your trade will open, and appear in the 'Toolbox' window as an active trade
  • To close your trade, double click the active trade and click the 'Close' button

To see the full process in the platform itself, watch the video below: 

Final Thoughts 

You should now have an answer to the question “what are CFDs”, as well as knowing how they work, some of their advantages, risks and how you can start trading CFDs.

As you can see, CFD trading offers the opportunity to trade a wide range of markets for a relatively low deposit. With the use of leverage, you can amplify your profits (and losses) and with the ability to go long or short you can attempt to profit in both rising and falling markets. 

However, as with any form of investing, there is the very real possibility of losing money as well as making it. That’s why it's crucial to educate yourself. Ensure you have a good knowledge of the markets, a trading strategy and a reliable platform to maximise your chances of success. 

Trade CFDs With Admirals 

If you are feeling inspired to start trading CFDs, the Trade.MT5 account from Admirals may be the perfect place for you! A Trade.MT5 account allows you to trade CFDs on Forex, commodities, shares, ETFs, stock indices and more! In order to open an account and start trading CFDs, click the banner below:

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About Admirals 

Admirals is a multi-award winning, globally regulated Forex and CFD broker, offering trading on over 8,000 financial instruments via the world's most popular trading platforms: MetaTrader 4 and MetaTrader 5. Start trading today

This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks

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