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What is CFD trading and how does it work?

Published on: 02/11/2021 | Modified on: 20/03/2023

A contract for difference is a financial derivative product that pays the difference in settlement price between the opening and closing of a trade. CFDs are a tax efficient* (UK) way of speculating on the financial markets and are highly popular amongst FX and commodities traders. CFD trading enables you to speculate on the rising or falling prices of fast-moving global financial markets, such as forex, stocks and shares, indices, commodities, and treasuries.

KEY POINTS

  • Speculate on both sides of the market by opening long or short positions
  • Traders can buy or sell a number of units and for every point the price of the instrument moves, you will make a profit or loss
  • CFDs are available globally and come with no stamp duty fees, although they are subject to capital gains tax*
  • They are a leveraged trading product, giving you greater exposure to the financial markets
  • CFDs can be used for hedging to offset losses from your existing portfolio

What are CFDs?

CFD meaning

The meaning of CFD is 'contract for difference', which is a contract between an investor and an investment bank or spread betting firm, usually in the short-term. At the end of the contract, the parties exchange the difference between the opening and closing prices of a specified financial instrument, which can include forex, shares and commodities. Trading CFDs means that you can either make a profit or loss, depending on which direction your chosen asset moves in.

What are contracts for difference?

Contracts for difference are financial derivative products that allow traders to speculate on short-term price movements. Some of the benefits of CFD trading are that you can use margin trading, and you can go short (sell) if you think prices will go down or go long (buy) if you think prices will rise. CFDs have many advantages and are tax efficient in the UK, meaning that there is no stamp duty to pay. Please note, tax treatment depends on individual circumstances and can change or may differ in a jurisdiction other than the UK. You can also use CFD trades to hedge an existing physical portfolio. With a CFD trading account, our clients can choose between holding positions in the long-term and quick day trading strategies.

How does CFD trading work?

With CFD trading, you don't buy or sell the underlying asset (for example a physical share, currency pair or commodity). Instead, you buy or sell a number of units for a particular financial instrument​, depending on whether you think prices will go up or down. We offer CFDs on a wide range of global markets, covering currency pairs, stock indices, commodities, shares and treasuries. An example of one of our most popular stock indices is the UK 100, which aggregates the price movements of all the stocks listed on the UK's FTSE 100 index.

For every point the price of the instrument moves in your favour, you gain multiples of the number of CFD units you have bought or sold. For every point the price moves against you, you will make a loss.

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What is margin and leverage?

Contracts for difference (CFDs) is a leveraged product​, which means that you only need to deposit a small percentage of the full value of the trade in order to open a position. This is called ‘trading on margin’ (or margin requirement). While trading on margin allows you to magnify your returns, your losses will also be magnified as they are based on the full value of the position. This means that you could lose all of your capital, but as the account has negative balance protection, you can't lose more than your account value.

Learn more about CFD margins​ and how to calculate CFD margins​.

What are the costs of CFD trading?

Spread: When trading CFDs, you must pay the spread, which is the difference between the buy and sell price. You enter a buy trade using the buy price quoted and exit using the sell price. The narrower the spread, the less the price needs to move in your favour before you start to make a profit, or if the price moves against you, a loss. We offer consistently competitive spreads.

Holding costs: At the end of each trading day (at 5pm New York time), any positions open in your account may be subject to a charge called a 'CFD holding cost'. The holding cost can be positive or negative depending on the direction of your position and the applicable holding rate.

Market data fees: To trade or view our price data for share CFDs, you must activate the relevant market data subscription, for which a fee will be charged. View our market data fees.

Commission (only applicable for shares): You must also pay a separate commission charge when you trade share CFDs. Commission on UK-based shares on our CFD trading platform starts from 0.10% of the full exposure of the position, and there is a minimum commission charge of £9. View the examples below to see how to calculate commissions on share CFDs.

Example 1 - Opening a share CFD trade

A 12,000 unit trade on UK Company ABC at a price of 100p would incur a commission charge of £12 to enter the trade:

12,000 (units) x 100p (entry price) = £12,000 x 0.10%

= £12

Example 2 - Opening a share CFD trade

A 5,000 unit trade on UK Company ABC at a price of 100p would incur the minimum commission charge of £9 to enter the trade:

5,000 (units) x 100p (entry price) = 5,000 x 0.10%

= £9 (As this is less than the minimum commission charge for UK share CFDs, the minimum commission charge of £9 would be applied to this trade.)


Please note: CFD share trades incur a commission charge when the trade is opened as well as when it is closed. The above calculation can be applied for a closing trade; the only difference is that you use the exit price rather than the entry price. Learn more about CFD commissions​ and trading costs.

Which instruments can I trade?

When you open a CFD trading account with us, you can take a position on thousands of instruments, including forex trading. Our spreads start from 0.7 points on forex CFDs, including the EUR/USD and AUD/USD currency pairs. You can also trade the UK 100 from 1 point, Germany 40 from 1.2 points, and Gold from 0.3 points. See our range of markets. You can also trade share CFDs, which means that you do not have to take ownership of the physical share.

Read about the differences between CFDs and share trading​ to ensure that CFD trading is the right product for you.

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Pricing is indicative. Past performance is not a reliable indicator of future results.

Trade CFDs on more than 12,000 instruments

Example of a CFD trade

Buying a company share in a rising market (going long)

In this example, UK Company ABC is trading at 98 / 100 (where 98 pence is the sell price and 100 pence is the buy price). The spread is 2.

You think the company’s price is going to go up so you decide to open a long position by buying 10,000 CFDs, or ‘units’ at 100 pence. A separate commission charge of £10 would be applied when you open the trade, as 0.10% of the trade size is £10 (10,000 units x 100p = £10,000 x 0.10%).

Company ABC has a margin rate of 3%, which means you only have to deposit 3% of the total value of the trade as position margin. Therefore, in this example your position margin will be £300 (10,000 units x 100p = £10,000 x 3%).

Remember that if the price moves against you, it’s possible to lose more than your margin of £300, as losses will be based on the full value of the position.

Outcome A: a profitable trade

Let's assume your prediction was correct and the price rises over the next week to 110 / 112. You decide to close your buy trade by selling at 110 pence (the current sell price). Remember, commission is charged when you exit a trade too, so a charge of £11 would be applied when you close the trade, as 0.10% of the trade size is £11 (10,000 units x 110p = £11,000 x 0.10%).

The price has moved 10 pence in your favour, from 100 pence (the initial buy price or opening price) to 110 pence (the current sell price or closing price). Multiply this by the number of units you bought (10,000) to calculate your profit of £1000, then subtract the total commission charge (£10 at entry + £11 at exit = £21) which results in a total profit of £979.

Outcome B: a losing trade

Unfortunately, your prediction was wrong and the price of Company ABC drops over the next week to 93 / 95. You think the price is likely to continue dropping so, to limit your losses, you decide to sell at 93 pence (the current sell price) to close the trade. As commission is charged when you exit a trade too, a charge of £9.30 would apply, as 0.10% of the trade size is £9.30 (10,000 units x 93p = £9,300 x 0.10%).

The price has moved 7 pence against you, from 100 pence (the initial buy price) to 93 pence (the current sell price). Multiply this by the number of units you bought (10,000) to calculate your loss of £700, plus the total commission charge (£10 at entry + £9.30 at exit = £19.30) which results in a total loss of £719.30.

Short-selling CFDs in a falling market

CFD trading enables you to sell (short) an instrument if you believe it will fall in value, with the aim of profiting from the predicted downward price move. If your prediction turns out to be correct, you can buy the instrument back at a lower price to make a profit. If you are incorrect and the value rises, you will make a loss. This loss can exceed your deposits.

What are the risks?

  • When trading with leverage, you could make large losses if your bet is unsuccessful and the market moves against you.

  • If you don't have sufficient funds in your account to cover balance changes, there is a risk that your positions may be closed out.

  • The financial markets can be volatile, especially the stock and forex markets.

  • There are a number of extra fees associated with CFD trading that traders often forget, including holding costs, commissions on shares, and GSLO premiums.

Hedging your physical portfolio with CFD trading

If you have already invested in an existing portfolio of physical shares with another broker and you think they may lose some of their value over the short term, you can use a CFD hedging strategy​. By short selling the same shares as CFDs, you can try and make a profit from the short-term downtrend to offset any loss from your existing portfolio.

For example, say you hold £5000 worth of physical ABC Corp shares in your portfolio; you could hold a short position or short sell the equivalent value of ABC Corp with CFDs. Then, if ABC Corp’s share price falls in the underlying market, the loss in value of your physical share portfolio could potentially be offset by the profit made on your short selling CFD trade. You could then close out your CFD trade to secure your profit as the short-term downtrend comes to an end and the value of your physical shares starts to rise again.

Trading CFDs means that you can hedge physical share portfolios, which is a popular strategy for many investors, especially in volatile markets.

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FAQs

How can I trade CFDs?

You can trade CFDs by opening a live CFD account, or alternatively, you can practise risk-free with virtual funds on a CFD demo account. We offer a wide range of financial markets to trade on, including forex, indices, commodities, shares, ETFs and treasuries.

How long can you hold CFD contracts for?

On most instruments, you can hold CFD contracts for as long as you wish, depending on your trading strategy. This can be any duration between a matter of seconds to several months. However, there are extra costs to take into consideration when carrying overnight positions. Learn more about CFD holding costs.

Is CFD trading good for beginners?

CFD trading is suitable for all levels of trading experience, from beginner to professional. We have a vast range of resources to help beginners get started and you can also open a demo CFD trading account to practise risk-free with virtual funds.

Is CFD trading tax-free?

No, contracts for difference are not tax-free. When trading CFDs, you’re subject to capital gains tax, but there is no stamp duty to pay. An alternative, tax-free product is spread betting. Read about the differences between spread bets and CFDs to find the product most suitable for you.

Can you lose more than you invest in CFDs?

You can lose more capital than you deposit on a trade when trading CFDs with leverage, because leverage acts as a double-edged sword, meaning that profits and losses are based on the full value of the trade, depending on whether the market moves in your favour. However, with negative balance protection, you can never lose more than your account value. Read about the risks of CFDs and how to combat them in our risk-management guide, such as using stop-loss orders.


*Tax treatment depends on individual circumstances and can change or may differ in a jurisdiction other than the UK.

CMC Markets is an execution-only service provider. The material (whether or not it states any opinions) is for general information purposes only, and does not take into account your personal circumstances or objectives. Nothing in this material is (or should be considered to be) financial, investment or other advice on which reliance should be placed. No opinion given in the material constitutes a recommendation by CMC Markets or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person. The material has not been prepared in accordance with legal requirements designed to promote the independence of investment research. Although we are not specifically prevented from dealing before providing this material, we do not seek to take advantage of the material prior to its dissemination.

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