What are Contracts for Difference (CFDs)?

Contracts for Difference (CFD) are financial instruments that allow traders to speculate on the price movement of an underlying asset (stocks, commodities, cryptocurrencies, etc) without owning it. When you trade CFDs you’re speculating on whether the asset’s price will go up or down. There is no delivery of securities or physical assets with CFD trades. 

In addition, Contract for Difference CFD instruments are used primarily by experienced traders due to their advanced nature and trading CFDs is not allowed in the United States. 

Key Concepts of Contracts for Difference

• CFDs are financial contracts that pay the difference in the settlement price from the opening and closing trades
• The CFD trader can use CFDs to trade the direction of securities over a short timeframe 
• CFDs, though, cash-settled, permit ample leverage trading
• CFDs are volatile due to rapid price fluctuations resulting in increased risk 
• When Trading CFDs you can go long (buy) if you speculate the price will rise and short (sell) if you believe the price of the underlying asset will fall 
• You can trade CFDs with a wide range of underlying assets including indices, currencies, cryptocurrencies, commodities, stocks, etc
• Trading CFDs attracts broker (CFD providers) fees such as spreads (the difference between bid and ask costs), commissions, and overnight/swap fees
• CFD trading is built to mimic its underlying asset market closely. The prices are typically only driven by the movements of the underlying asset market

What is CFD Trading? (Contracts for Difference Trading Examples)

To understand what a CFD trade is, let’s see examples of trading CFDs with cryptocurrency and stock underlying assets. 

Trading CFD Shares (Long CFD Trade Example) 

A Share CFD trade allows the trader to speculate on the price of the underlying stock. For instance, Apple Shares CFD mirrors the price of Apple stock. When people invest in Apple stock, they must pay the full price upfront to take ownership of the shares. They can realize gains only when the stock price rises and they sell the shares. Additionally, owning shares may provide dividends, whereas CFDs typically do not.

With CFDs, when traders trade Share CFDs, they are just trading its price movements, which gives them the advantage of speculating price movements in any direction (long or short). 

That said, if Apple is trading at $288.00 / $288.50, this implies that traders can purchase Apple at $288.50 and sell it at $288.00. Apple, for example, has a margin requirement of 5%, which means the trader only has to set aside 5% of the position’s value as margin. 

Assuming the trader buys 1 Apple CFD at $288.50, speculating that it will hit $300 in a couple of hours, there are 2 outcomes: 

The first outcome is that Apple shares rise and hit the $300 mark, so the trader closes their position (sells Apple). The outcome is that the trader bought Apple at $288.50 and sold it at $300, which gave them an outcome of +$11.50. 

Alternatively, if Apple shares fall; the trader bought Apple at $288.50 and sold it at $280, which means they lost $8.50 on the position. 

Trading Cryptocurrency (Short Trade Example)

Trading crypto CFDs is done via the CFD providers’ trading platforms and does not require the use of a digital wallet. Also, since CFDs do not require the trader to purchase the underlying asset, they allow the use of leverage which reduces the initial capital investment while gaining the full value of a position.  

That said, say Bitcoin is trading at $50,230 / $50,260, this means traders can buy Bitcoin at $50,260 and sell it at $50,230.

Let’s assume that the crypto market is down and traders still speculate a downtrend. They decide to sell 1 Lot of BTC/USD at $50,230, speculating the price to drop to $48,000 with their stop loss order set at $51,000. The BTC CFD margin trading requirement in this example is 1%. 

There are 2 outcomes. The first is that the Bitcoin fall continues, and BTC’s price keeps falling till it reaches $48,000 as speculated by traders. In this event, they sold 1 contract of BTC/USD at $50,230 and purchased it at $48,000, with a price difference of +$2230. 

The second outcome is that the trader’s speculation is wrong and the Bitcoin bounces back and gains upward momentum, hitting the stop loss order set at $51,000. In this event, traders sold 1 contract of BTC/USD at $50,230 and bought it at $51,000, with a price difference of -$770 on their position. 

That said, it is important to note that CFDs are inherently risky as they involve leverage, which exposes your position to greater losses. 

How to Start CFD Trading

Understand the Basics 

Before you start trading, you need to gain a basic understanding of CFDs, the financial markets, and how they work. You need to understand basic concepts like leverage, long or short, risk management, position sizing, etc. CFDs are complex instruments and come with a high risk of loss, due to leverage so education is crucial before you begin. Most brokers offer educational resources that feature articles, coaching sessions, podcasts, video tutorials, etc. to help you get started. 

Choose A CFD Broker 

The next step in your CFD trading journey is to choose a CFD broker that suits your goals and the financial markets you want to trade. There are many CFD brokers in the market and choosing the right one may be confusing especially if you are a beginner. So consider the following factors when looking for a CFD broker:

• Regulation: A good broker must be regulated by a reputable financial authority, as this ensures that the brokerage platform adheres to industry standards. 
• Security: Ensure that the broker has the appropriate security measures in place. This includes measures like segregation of client funds from company funds, data protection policies, encryption protocols, etc. 
• Variety of Assets: It is usually best to choose a broker that offers a variety of CFD assets as this will allow you to diversify your portfolio. Also, ensure that the broker has good liquidity as this can affect the slippage and price execution. 
• Platform Features: Go for a platform that offers a variety of features (basic and advanced). This includes features like technical indicators, charting tools, risk management tools, and customizable layouts. Also, ensure that the platform has a user-friendly interface that is easy to navigate and offers a mobile trading app. 
• Fees: Compare the spreads and commissions of various brokers to see which is best for you. In most cases, it is best to choose a broker with tight spreads and fees. 
  Also, check for financing costs, overnight fees, and additional fees that can impact the overall trading cost. 
• Customer Service: You should choose a broker that offers timely and effective customer support via any of their support channels. Also, consider the availability of educational resources and a well-equipped help center that provides meaningful information on how to navigate the platform. 

Open An Account 

Once you have chosen the right CFD broker that suits your needs. The next step is to open an account with the broker. 

The account opening process usually involves providing some required personal data and filling out necessary forms to verify your identity. Once you have created the account, you can proceed to deposit money into your trading account. 

Develop A Trading Plan 

Before you start live trading, you should develop a trading plan. This will help you stick to your trading goals. Vital aspects of your trading plan include setting your trading result goals, setting your trading budget, developing a trading strategy, and choosing your risk management strategies. 

Practice With A Demo Account 

Practice with a demo account before you start trading with real money on the live account. 

Demo trading offers you risk-free trading because trading is done with virtual funds. 

The demo account simulates live market movements, which enables you to know how your strategies will perform in the live market. Demo trading will also enable you to get familiar with the trading platform before you start trading. 

Start Small And Increase Gradually 

Once you have proven your strategy via demo trading and are confident to start trading on the live account, it is best to start small. CFD trading is quite complex and the best way to manage the risk is to start small and then increase your capital gradually as you improve your trading skills. Evaluate your trades and learn from your mistakes. 

Can You Trade CFDs with a Funded Account?

Yes, you can trade CFDs with a Funded Account. Most funded programs offer traders trading capital to trade various types of CFDs. 

Trading CFDs with funded accounts offers several benefits that independent traders may not have. 

Below are some of the benefits of trading CFDs with a funded account: 

• High Trading Capital: The primary benefit of trading CFD instruments with a funded account is access to large trading capital. Most funded programs offer potential traders up to $500,000 in funding, which most independent traders may not have for trading. 
• Variety of markets: Funded accounts often offer access to CFDs on a variety of underlying assets including commodities, cryptocurrencies, stocks, currencies, and Indices. This allows traders to diversify their portfolios without trading on multiple platforms. 
• Leverage: Most funded accounts offer traders high leverage, this enables traders to open larger CFD positions with a small amount of capital. Since funded traders have access to more trading capital than independent traders, this can drastically boost the size of the position. 
• Risk Management: Traders often have access to a lot of risk management tools on funded accounts. This is because the funded programs are interested in protecting their capital. Most funding programs have strict rules on risk management and mandate all funded traders to adhere to these restrictions. Failure to adhere to the rules can result in the loss of funding. This premium placed on risk management enables funded traders to be more disciplined to minimize the risks associated with CFD trading. 

Who is CFD Trading Best For?

Trading CFD instruments could be right for you if you’re searching for a way to trade rising or falling assets (you want to go long or short not just invest) and if you want to open positions using margin. That said, CFDs are risky and can result in you losing more than your initial deposit.

Due to the high risk involved, CFD trading is not for everyone. CFD trading is best for experienced traders who have a high-risk tolerance. This is because the use of leverage in CFD trading often amplifies the risk and CFDs are extremely volatile. 

CFD trading is best for traders who understand the complexity of CFDs fully understand the associated risks and are comfortable with the volatility. 

Aside from high-risk tolerance, you must also be willing to dedicate time and effort, this is because CFD trading requires continuous research and analysis. 

You must also have a long-term perspective as CFD trading is not a get-rich-quick scheme, time and patience are required.  

Conclusion 

Contracts for Difference are financial instruments that allow traders to speculate on the price movements of underlying assets without owning them. They offer leverage, do not facilitate the physical delivery of the underlying asset, are based on various assets, and are inherently risky due to market volatility and leverage. 

Before engaging in CFD trading it is important to be aware of the potential of significant losses and to conduct in-depth research on the underlying asset/CFD market you intend to trade. 

FAQ

Is a Contract for Difference an Option?

No, a CFD is an agreement to exchange the difference between an asset’s opening and closing price without actually owning the asset. In contrast, Options trading involves the right, but not the obligation, to buy or sell an asset at a predetermined price by a specific future date.

How do CFD Providers make Money?

CFD providers make money primarily from spreads and commissions charged on each trade opened by traders. 

What is the Difference between CFDs and Futures?

With CFDs, you sell a certain number of contracts of a financial asset if you predict it will fall and buy them if you expect it to rise. The value of the position changes in reflection of the price movement of the underlying asset. 

On the other hand, Futures contracts require you to trade the expected future price of an asset. Unlike CFDs, these contracts specify a fixed date and price for the transaction. The value of the futures contract changes based on the market sentiment of the future asset price as much as the current momentum of the underlying asset.  

Does a CFD Expire?

No, unlike Futures contracts, CFDs do not expire. 

Why Do People Trade Contracts for Difference? 

There are various reasons why traders opt for CFDs: 

• Leverage: CFDs are leveraged products, so traders can increase their position size beyond their trading capital
• Trade Flexibility: With CFDs, you can go long or short, which means you can trade irrespective of the direction of the market. This isn’t possible with investing. 
• Tax Benefits in Certain Locations: Leverage derivatives offer tax benefits in particular territories like the United Kingdom.