What is CFD trading?

What is CFD trading?

A CFD is a contract between a trader and a broker. The broker agrees to pay the difference in the price of an asset between the opening and closing price of a trade. The contract doesn’t involve ownership of the underlying asset, but traders can open ‘buy’ or ‘sell’ positions when they trade CFDs, based on which way they think the market might move. 

Another key feature of CFDs is the use of leverage. Trading with leverage means traders only need to put up an initial margin requirement to open a position, which is a pre-defined proportion of the full value of the trade. Trading on margin amplifies potential profits and losses equally, so it’s important to understand and manage your risk. 

How does CFD trading work?

With CFD trading, you buy or sell a number of units of a financial instrument, depending on whether you think the price will go up or down.

To illustrate this idea, let’s take as an example one of our most popular instruments, the US NDAQ 100, which is based on the price movements of the underlying US NASDAQ 100 index.

Imagine that you’ve carried out some research and you expect the index to rise in value. You therefore place a ‘buy’ trade on the US NDAQ 100. For every point that the price of the index moves in your favour, you would make a gain based on the number of CFD units that you bought. Similarly, for every point the price moves against you, you would make a loss.

What is leverage?

Leverage is using money borrowed from a broker to gain increased exposure to your chosen instrument. You put up a defined initial deposit, or margin, depending on the asset class and instrument you're trading. Your leveraged position then offers the potential for higher returns, as well as higher losses, as it's based on the full value of the trade.

Elaborating on the last point, when you open a CFD trade with a broker, you deposit the margin, while the broker provides the rest of the notional value of the position. While leverage gives you greater exposure to financial markets, it also increases your risk, as your profit or loss is based on the full notional value of your position.

How do CFD margins work?

Let’s imagine that a trader wants to go long on – or 'buy' – 10 shares of Tesla stock. For the purposes of this example, let's say the stock is trading at $1 a share. The full value of the position would be $10. However, the margin required to open this CFD trade is 20%, so you would only need $2 to enter the trade.

What’s the difference between going long and going short?

With CFD trading, you can choose to buy or sell a financial instrument. Buy (go long) if you think the price will rise, or sell (go short) if you think the price will go down.

Example of a CFD trade

Going long on shares via a CFD

Now let’s look at a more detailed example. Imagine that you want to speculate on the price movement of a (fictional) US-listed company called ABC. It’s trading at a sell price of 98¢ and a buy price of 100¢. This means that the spread is 2¢.

Based on your research of the market and ABC’s fundamentals, you think the company’s share price is going to rise, so you open a long position by buying 10,000 CFDs, or ‘units’, at 100¢ each. A commission charge of $10 is applied when you open the trade as the commission rate for US-listed companies is $0.02 (with a minimum fee of $10):

(10,000 units x 100¢ = $10,000) x $0.02 = $200

ABC has a margin rate of 20%, which means you need to deposit only 20% of the full value of the trade to open a position. Therefore, opening the position requires $2,000:

(10,000 units x 100¢ = $10,000) x 20% = $2,000

⚠ Remember, if the instrument's price moves against you, you could lose more than $2,000, as losses are always based on the full value of the position.

Because CFD trading uses leverage, the amount of money needed to open this position is less than the amount needed to open the equivalent non-leveraged deal, as this table illustrates:

Next, let’s continue this example by looking at two potential outcomes of this trade.

A profitable trade

Let's assume your prediction was correct. ABC rises over the next week to a sell price of 110¢ and a buy price of 112¢. You close your buy trade by selling at 110¢. Commission is charged at $0.2 (minimum $10) when you exit a trade too, so a charge of $11 is applied at this point:

(10,000 units x 110¢ = $11,000) x $0.02 = $220

The price has moved 10¢ in your favour, from 100¢ (the initial buy price or opening price) to 110¢ (the current sell price or closing price). Multiply this price rise by the number of units you bought (10,000) to calculate your profit ($1,000), then subtract the total commission charge ($200 at entry + $220 at exit = $420). The result is a total profit of $580, minus overnight holding costs.

A losing trade

In this scenario, let’s assume you were wrong, and the price of ABC drops over the next week to a sell price of 93¢ and a buy price of 95¢. You think the price is likely to continue dropping so, to limit your losses, you sell at 93¢ to close the trade. A commission fee of $0.02 is payable when you exit a trade, so a charge of $186 is applied:

(10,000 units x 93¢ = $9,300) x $0.02 = $186

The price has moved 7¢ against you, from 100¢ (the initial buy price) to 93¢ (the current sell price). Multiply this price movement by the number of units you bought (10,000) to calculate your loss ($700), then add the total commission charge ($200 at entry + $186 at exit = $386). The result is a total loss of $1,086, plus overnight holding costs.

How do you hedge an existing portfolio with CFD trading?

If an investor thinks their share portfolio may lose value in the near term, they could use a CFD hedging strategy to offset their losses. Let’s say an investor holds $5,000 worth of Tesla shares and is worried that the Tesla share price may fall. The investor could short, or sell, the equivalent number of units of Tesla via CFDs. Then, if Tesla’s share price falls in the underlying market, the loss in the value of the investor’s share portfolio could potentially be offset by the profit made on the short-selling CFD trade.

Trading CFDs to hedge a share portfolio is a popular strategy among investors, especially during periods of market volatility. It’s important to bear in mind that applicable fees, such as overnight holding costs, could impact this strategy, potentially lowering the expected return.

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Why trade CFDs?

• Flexibility: You can trade CFDs on a wide range of financial markets, including stocks, indices, forex, and commodities, enabling you to diversify your portfolio and seize potential opportunities in various markets.

• Leverage: CFD trading includes leverage, so you deposit only a percentage of the full value of the trade to open a position. Leverage magnifies potential gains and losses equally.

• Hedging: Trading CFDs as part of a hedging strategy may help you to offset the negative impact of a market downturn on your investment portfolio.

• Versatility: CFD trading can accommodate various trading strategies. Whether you favour day trading, scalping, or swing trading, you may be able to implement your preferred approach and react quickly to changing market conditions with CFDs.