What is CFD trading and how does it work

May 29, 2023

Increasingly popular amongst traders, contracts for difference are a way to speculate on a variety of asset classes without actually owning these assets.

In this article, we’ll break down what CFDs are, how they can offer traders opportunities, the risks associated with them and the CFD trading strategies you can use to manage CFD positions.

What is the meaning of CFDs?

CFD stands for contract for difference, and the ‘difference’ it refers to is the difference in an asset’s current price and its price at the nominated contract date. The difference can also be referred to as a ‘spread’. Whether the difference occurs through a rise or fall in prices is less important to a trader when using contracts for difference, as it is the movement itself that you are speculating on. Whether the underlying asset incurs a profit or a loss, you can still profit from holding a CFD position, either by holding onto that position for the long term or unloading it through short day trading.

What are CFDs?

CFDs are a financial derivative product, meaning they derive their value from another underlying asset or index. They can be used to both go short (i.e. sell) or go long (i.e. buy) in a position, and they can be used to hedge an existing physical portfolio, in order to shield you from potential losses.

They are generally considered to be a less costly and more flexible way to give traders access to a number of asset classes they wouldn’t otherwise be able to get exposure to. Traders will choose to hold long or short positions with CFDs, depending on where they think the market is headed.

How do CFDs work?

CFDs work by establishing a contract in which both buyer and seller agree to a date in the future, with the buyer being obligated to pay the seller the difference in the current price of the asset and its price at contract time.

Contracts for difference do not involve anyone taking possession of the underlying asset. Instead, they speculate whether the value of that asset will rise or fall, with options for traders to profit from both upward and downward movements in this price. Because of this, CFDs are an attractive trading option, allowing for profitable gains even when an asset is not performing well within the market.

What is CFD trading?

There are numerous ways a trader can approach taking positions within live markets. You may choose to learn about the foreign exchange and trade forex, or you may opt to trade indices and trade soft commodities and hard commodities. In all these cases, you probably think of trading and dealing directly with the asset, either through spot price or futures trading. However, CFD trading offers a different way to gain exposure to certain markets.

Rather than directly trading precious metals, for example, CFD trading lets traders speculate on the price movements in these markets, aiming to correctly predict these movements and take a long or short position accordingly.

In general, there are three principles of CFD trading you need to understand:

You choose to go long or short — Going long indicates you think the price of an asset will rise, and so you choose to buy it. Inversely, going short requires you to sell CFDs, on the basis of a prediction that the price will fall.
You deal with leverage and margin — CFDs are leveraged financial products. This means that they only require traders to put down a percentage margin of the asset’s true value, but that this marginal buy-in will grant you exposure to the asset’s full value. That means the full value of any loss or profit needs to be calculated according to the total asset value, not your initial deposit.
CFDs move with the market — Contracts for difference are designed to move in line with the price movements of an underlying asset on open markets. This isn’t an exact mirror of the market itself, but it is a good mimic.

Examples of CFD trades

In any CFD trade, there are two broad possible outcomes: a profitable trade or a losing trade. Let’s look at one example of these two outcomes, based on taking a long position. Remember, going long means buying in with the expectation that the asset’s price will rise.

Imagine commodity A is expected to increase in price, according to your analysis. You decide to buy 1,000 CFDs, also known as units, at $10 apiece. You may also need to pay a separate commission charge on these units, calculated as a fractional percentage of their price. The total value of the position is $10,000, plus any commission paid.

However, as CFDs are leveraged, the amount you will outlay in your deposit is based on the company or commodity’s margin rate. In our example, we’ll say that the rate is 20%, so rather than paying $10,000, your trade position margin that you will pay is $2,000. Whether you profit or lose from your position, the full value of the trade will be used to determine the difference.

Outcome 1: a profitable trade

In this scenario, you correctly predicted the price of commodity A would rise, and it is now selling at $11 a unit. You decide to sell your units at this price, and each unit you sell is now $1 higher in your favour. You may also be charged an exit commission at this point, so your profit will be $1,000, minus the entry and exit commission fees from the trade.
Outcome 2: a losing trade

You made a bet, and it didn’t go off — commodity A’s stock dropped to $9.30. Wanting to minimise your losses, you sell off your CFDs at this price. In this scenario, the unit price has moved 70 cents against you, so although your initial buy-in was $2,000, your loss in real terms is $700. Again, entry and exit commission fees need to be added to this to determine the full amount.

Deciding if CFD trading is right for you

In order to decide whether you want to start trading CFDs, you need to understand the reasons why people choose to do so. Some of these include:

More flexibility — Unlike some financial products, contracts for difference allow you to both buy and sell, so you still trade no matter which direction the market is headed in.
Less initial outlay — The capital required to buy into a CFD is less than other financial instruments, giving you a cost-efficient way to trade a wide variety of different asset classes.
Longer hours — In some markets, CFD trading continues for longer than the trading times of asset markets. For some traders, this gives them a tactical advantage, although it can also affect prices during out-of-hours trading.
Less potential loss — While CFDs can magnify both profit and loss because of leveraging, they are also useful for hedging your existing portfolio against loss. For example, a trader might open a position based on the expected loss on an underlying asset they are also invested in, in order to mitigate any loss that might occur from a fall in the market price.

You’ve probably noticed that all of these reasons involve putting much of the decision-making squarely in the hands of the investor. CFDs offer a lot of freedom to traders, but with increased options come increased risk and complexity with any decision. In deciding whether CFD trading is right for you, you need to consider how this complexity will affect your ability to make strategic trades and whether you feel experienced enough to jump into this financial instrument.

VT Markets — your broker partner for CFD trading and more

AT VT Markets, we aim to provide a transparent trading environment and a plethora of trading tools and insights to help you manage your trading portfolio, no matter what your exposure or strategy.

Whether you want to develop your skills and knowledge as a trader by using contracts for difference, learn more about trading energies or hone your ability to read market trends, our team can help you get started with a powerful platform and the tools you require. Contact us today to learn more.

FAQs

Is trading CFDs safe?

Trading using any kind of financial product or instrument involves a degree of risk and requires research and knowledge in order to read the market and make the right strategic moves. No trade is completely ‘safe’, and there is always a chance that you may lose money rather than make a profit.

Unlike share dealing, trading CFDs involves trading financial derivative products that require leverage. This means traders require less capital to gain full exposure to the product than they might with other assets. Leverage can amplify the amount of profit you make, but it can also magnify the loss. For this reason, it’s important to establish appropriate risk management tools to control potential losses.

If you want to practise opening and closing positions, watching for market trends and coming to grips with the complex financial instrument that is contracts for difference, a great way to do this is with a VT Markets demo account. This account will give you access to all the trading tools and insights you need to start practising trades in a no-risk and obligation-free 90-day trial. You can also become familiar with VT Markets’ powerful trading platforms and live trading environment before you start trading with your own money.

Are CFDs traded in all international markets?

Currently, CFD trading is not permitted within the US market, because they are a type of over-the-counter product (or OTC) that bypasses regulated exchanges. CFDs are legal to trade in the UK; however, they do attract taxation, unlike spread betting.

How can I get started trading CFDs?

AT VT Markets, it only takes a few minutes to get started with a live account and begin trading CFDs. Along with powerful platforms MetaTrader 4 and MetaTrader 5, we offer all of our clients access to state-of-the-art trading tools, expert advice, market analysis and investor insights. Create your account today and start operating in a secure trade environment.