What are CFDs and How to Trade with Them
CFDs allows you to trade up or down on the price of stocks, cryptocurrencies, stock market indices, currency exchanges and more. In this article we will explain what CFDs are and how they work in detail.
Table of Contents
- What are CFDs?
- How CFDs Trading Works
- Which Markets Can You Trade CFDs?
- Trading via Desktop, Browser or Mobile App
What are CFDs (Contract for Difference)?
CFDs have been used for over 20 years now and have offered a great opportunity to all those who do not have large amounts of capital but can turn their trading skills into an economic income.
CFD is an acronym that stands for Contracts for Difference. In fact, they are standardized contracts and because of this characteristic they are very practical, so much so that they can be negotiated with a single mouse click.
To trade CFDs there is no need to fill out forms and sign authorizations as in the purchase of shares. It is also just as easy to close investment transactions, with an instant close when you want. Thus, CFDs are investment instruments that are characterized by their convenience and speed of execution.
Each CFD contract replicates the performance of a financial asset, so for example the Tesla CFD will replicate the performance of the Tesla stock on the stock exchange, just as the GBP/USD CFD will replicate the performance of the exchange rate between the British pound and the US dollar. Again, the Bitcoin CFD will replicate the price of Bitcoin and so on. Once you enter a CFD position here's what happens:
- If the security price goes up, those who opened a "Buy" position gain, or if the security price goes down, those who opened a "Sell" position gain.
- In CFD trading, you can open Buy (bullish) positions as well as Sell (bearish) positions.
Negociating CFDs on a Trading Platform
When you click on "Buy", you open a bullish position. The trader buys Long contracts, which allow him to obtain capital gains proportional to increases.
When clicking on "Sell", a bearish position is opened. The trader buys Short type contracts, which allow him to make gains proportional to the declines.
In order to trade CFDs, it is necessary to access a CFD trading platform. The trading platforms from several brokers present the price chart in real time, functions to open "Buy" and "Sell" positions, the list of tradable securities and many other functions that we discuss further.
A CFD trading platform allows you to place orders to the broker, which can be of various types: opening and closing market buy or sell positions, stop-loss, take-profit, trailing stop-loss, and pending orders (sell limit, buy limit, buy stop, sell stop).
Advantages of Trading With CFDs
Trading with CFDs has many advantages, which we could summarize as cost effective, compared to traditional investment, convenience, and speed.
With CFDs, in fact, retail investors have the opportunity to trade online from their computer, smartphone or tablet, with virtually no bureaucracy slowdowns, compared to what a traditional investment requires.
For example, you do not have to hold paper securities, deposited in a bank and tradable only upon consultation and request. CFDs can be traded electronically and with a click and open positions can be closed after only a few minutes. This means that you can take advantage of upswings lasting only a few minutes and then close the position and make a profit.
Unlike the stock market, another great advantage is that with CFD trading you can also profit from falling prices. To do this, you do not have to hold the security, or to buy and then sell, but simply open short or "sell" positions.
How Does the CFDs Trading Works?
How does the trading of this instrument technically work? CFD trading takes place between individual investors and companies that offer this service, namely brokerage firms or brokers. Since there are no standard contracts for CFDs, each company can determine their own, while sticking to some common points such as:
- The CFD begins when the user (the investor) opens long or short position on a given instrument and ends when he closes that same position.
- The gain or loss of the investor will be proportional to the price variation occurred between the opening and closing of the position.
As compensation for its service, the broker usually applies a spread between the purchase (bid price) and the sale (ask price) at the opening. The broker can also add commissions for opening and closing a position, according to their fees/commissions structures, overnight rate (swap fee) and in some rare cases even a managerial fee in case the service is a portfolio management.
CFDs are leveraged products, which means that the trader or investor must always maintain the minimum margin level required. In the event that the account equity falls below the minimum margin level, the CFDs broker will make a margin call asking the trader to quickly cover those margins, which will otherwise lead to the automatic closing of the positions by the broker, in order to protect itself.
A very important aspect to understand regarding CFDs trading is that of margin. First of all, let's distinguish the two types of margin in CFD trading:
- Initial Margin: This is the amount that the trader will actually invest for the position, and it is calculated by getting the ratio between nominal capital and leverage (i.e., if nominal capital is $5,000 and leverage is 50:1, initial margin will be $100)
- Maintenance Margin: This is the margin that is required to keep the position open and is returned when the position is closed.
Let's take an example. A trader has a $1,000 trading account and wants to open a position of 0.01 lot on the USD/CHF pair. With a 30:1 leveraged account the initial margin will be equal to $33.33 ($1,000/30). Of this, if the maintenance margin is 30%, $9.99 will be frozen. Typically, the maintenance margin for Forex CFDs trades is between 25% and 40% of margin used in a particular trade. The exact percentage depends on the CFDs broker.
The maintenance margin will be returned when the operation is closed. The maintenance margin is important because the equity must always remain quite far from it, in order not to run into a margin call, which is a warning that a losing position has reached critical levels.
How Much Does it Cost to Trade CFDs?
The answer to the costs can be included among the advantages because as we have seen in detail, trading with CFDs requires much lower amounts than other traditional investment.
The spread and the commissions, or what the CFD broker charges for its service, are lower and much smaller than the trading commissions charged by most banks and other brokers operating as intermediaries on the stock markets.
Usually, Forex CFDs offer the lowest spreads, which can be as low as 0 pips, also due to increased competition in the sector. Online CFDs brokers in fact profit from the commission applied to opened positions, so the more positions the traders open, or the higher the trading volume through the broker system is, the more the broker earns.
Main Difference Between Stocks and Financial CFDs
Unlike stocks, CFDs trading does not require the ownership of securities, so there is no need for the multiple paperwork and costs involved in a traditional equity investment, such as heavy commissions or management fees.
Although CFDs are not securities that you actually own, you can trade them quickly and conveniently for short-term profits. Most CFDs have no expiration date, so you are free to keep your positions open for as long as you wish, but you will incur overnight costs (swap rates) that must be paid back to the broker in exchange for keeping the position overnight.
On Which Markets Can You Trade CFDs?
CFDs allow traders to open positions, long or short on multiple financial instruments such as currencies, stocks, commodities, ETFs, indices and more recently cryptocurrencies.
Forex CFDs Trading
Forex CFDs grant retail investors the opportunity to trade on the currency exchange market, opening buy or sell on several currency pairs such as EUR/USD, USD/CAD, USD/JPY and many others.
The advantages of trading Forex CFDs include the high leverage offered by several brokers, about 500:1, restricted to 30:1 in Europe, and the lower spreads, which are more favourable than other financial instruments.
Regarding Forex CFDs trading it should also be noted that the classic MetaTrader 4 trading platform is one of the best apps for trading Forex, available in web, desktop and mobile versions.
Cryptocurrencies CFDs Trading
Cryptocurrencies are the latest craze in the financial markets. They have boomed in recent years, especially Bitcoin, reaching an all-time high of $35,000! For a single Bitcoin!
With CFDs, by now you must have understood, that you can trade on leverage both long and short positions, and that you don’t need $35,000 to trade the BTC/USD, expecting it to rise even more, or to fall.
Since cryptocurrency price movements are very volatile, this offers large profit margins. However, there is a flaw to cryptocurrencies CFDs. The spreads for crypto trading are usually higher, compared to FX, and the leverage is lower, up to 5:1. In practice, you need more starting capital compared to other financial instruments and especially compared to Forex trading.
Commodities CFDs Trading
Commodities CFDs trading offers retail investors the possibility to participate in trading some of the major commodities, like, gold, silver, copper, oil, natural gas and soft commodities such as cocoa, soybeans, coffee, sugar, cotton, etc.
ETFs CFDs Trading
ETFs (Exchange Traded Funds) are special funds whose shares are traded like normal stocks and are characterized by high liquidity and low management costs. ETFs CFDs enable investors to trade some of the most popular ETFs from global financial companies and banks, such as Merrill Lynch, JP Morgan, Barclays, etc.
Stock Indices CFDs Trading
Indices CFDs usually refer to the main indices of global stock markets, such as the Dow Jones, FTSE, NYSE, DAX, CAC, etc. Indices are formed by the stocks of a selected group of companies listed on a public stock exchange and measures the price performance of those companies intended to replicate a certain area of the market, such as technology, pharmaceutical, industrial, etc.
CFDs Trading via Desktop, Browser or Mobile App
In order to trade CFDs, you’ll need two things. Firstly, a valid trading account (real, not demo) with a CFDs broker. We suggest a quick check to our Best Forex Brokers in 2021 With Customer Reviews article to find a reputable one.
Secondly software that allows you to access the market and place orders. These software’s are commonly called CFDs trading platforms and are usually offered to download for free by the brokers you sign up with. It should be noted that CFDs trading is also possible without downloading any software or apps, through browser-based access. Compatible systems depend on the software offered by the broker.
One of the most popular CFDs trading platforms, offering robust connections and enhanced trading security is the MetaQuotes MetaTrader 4 and MetaTrader 5. Both platforms are tried and tested and come packed with an array of technical studies and indicators, suitable for deep technical analysis with the plus of running custom coded indicators and EAs (Expert Advisors) for automated trading.
MetaTrader 4 and 5, although not as efficient and complete as the desktop and web-based versions, offers a valid alternative to trade on the go, or to just simply follow the price action of multiple instruments, flawlessly.
On a final note, CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. CFDs trading involves substantial risks, including complete possible loss of funds and other losses and is not suitable for everyone.
You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money. We strongly suggest that you should, before diving into trading CFDs with real money, practice with a demo account for as long as you feel needed, and especially, until you learn and master how to properly manage money and risk to understand how much you should risk per trade and to how survive for longer while trading CFDs.