What is CFD in Trading?
Many people ask “what does CFD stand for?” Quite simply, CFD stands for “contract for difference”. Trading contracts for difference or CFDs is a way for traders to speculate on markets without actually having to own an underlying asset. A CFD is essentially a contract between a buyer and a seller. The contract holds that the buyer of the CFD must settle the difference in cash between the current value of the financial instrument and its value when exiting the trade position.
So, while you may not technically own an underlying asset you can still see financial gains based on the price movement of that asset in the market. Cool right? The CFD trading format can be described as a form of betting in and of itself. This is because you are betting your money on a financial instrument either dropping in price or rising in value. This is what is known as going long or going short. The idea is actually very straightforward. The difference in price between the CFDs that you entered the trade at and the price that you exited the trade at (sold your CFDs for) will equal the profit you made from the CFD trade. You can also check out our answer to the question “What is forex?” to learn about another form of trading.
Understanding what CFD leverage is
The reason so many experienced traders can make significant gains from CFD trading is largely put down to how well they take advantage of leverage. A broker will allow traders to trade on margin which means that they will grant them access to larger trade amounts without having to invest the full amount of the trade or the full exposure of the trade.
To put this more simply, you deposit a certain amount to open the trade and then borrow the rest of the value from the broker to cover the full amount i.e. leveraged trading. The amount of leverage you can trade with can vary significantly from anywhere between 2% and 20%. This can be a little tricky to grasp right off the bat but the best way for you to understand is by checking out a real-world example.
An example of trading CFD on margin
As an example, a trader is interested in buying Tesla shares. At the moment, one Tesla share is valued at around £500. You decide that you fancy Tesla’s shares to keep growing so you want to go long and buy 100 Tesla CFDs (shares). The total amount of the purchase would then be £50,000. This is pretty steep and you aren’t too sure that you can cover that amount yourself. However, the leverage offered on the trade is 90:10 which means that you will only need to cover 10% of the total value of the trade, also known as your exposure. That would mean that you would only need to deposit £5,000 to be entitled to the full value of the £50,000 when you enter the trade.
As we mentioned before, the broker is going to cover the rest of your trade so while you deposit the £5,000, the broker will cover the other £45,000. With that in mind, it’s important to remember that there are two sides to this coin. You are entitled to 100% of the profits made on the £50,00 trade but you are also fully responsible for any losses as well. If all goes well by the end of your trade window and the price of a Tesla share has risen to £550 you would be looking at a healthy profit.
Specifically, a profit of £5,000. But how did we get to this total profit amount? Easy, it is the difference between the price that you entered the trade at versus the price when you exited the trade. In a simple sum: £50 x 100 CFDs (shares) = £5,000. Remember, you aren’t walking away with £55,000 when you exit the position as you need to settle with the broker first. So, you settle the amount that they covered for you which was £45,000 and you walk away with £5,000.
CFDs can be a genuinely lucrative form of trading when done correctly. However, as every broker in the UK and EU will tell you (by law), CFD trading can be incredibly risky as well. If the price point of the CFD moves in the opposite direction that you “bet” on then you are liable for the full amount of those losses as well when trading on margin. With that in mind let’s take a look at some of the costs involved with CFD trading.
Trading Costs – What is CFD Trading Going To Cost Me?
There are a couple of different CFD trading costs that you will run into when opening, holding and closing your position. These costs can add up so it’s always best to be aware of them before continuing on with your trade.
A spread is the difference between the buy and sell price on a broker’s trading platform. You will always need to pay the spread on a CFD trade when entering a position. So, you enter a buy trade using the buy price and exit by using the sell price. Straightforward stuff. The smaller the difference between the buy price and the sell price means that the price point of the CFD does not need to move as much for you to make a profit. The same can be said for your losses. So, always look for competitive, narrow spreads on your CFD trades.
Holding your position overnight
If you decide to hold a CFD trading position overnight (past 5pm) then you may be subject to holding costs. Your holding costs can be positive or negative depending on your position. If you are in a buy position then you will be charged a fee but if you are in a sell position then you will be credited a certain amount. It will depend on the broker you are using.
You will more than likely need to pay a commission charge when you trade share CFDs. It will generally be a percentage of the total exposure of the trade. This may vary from broker to broker but the fees aren’t usually exorbitant. Unless of course, you are trading a significant amount of CFDs. For example, the broker may charge a 0.10% fee. So, if your buy position was £10,000 then the broker commission fee would be £10. Look for the cheapest broker so that your commission fees aren’t exorbitant.
CFD Trading Tips – Things To Keep In Mind
Now that you can better answer the question “what is CFD trading?” and know what some of the costs are, we want to sure up that knowledge with a few useful tips on how to trade CFDs more successfully. It’s a risky business trading CFDs so it’s in your best interest to keep these tips in mind going forward.
Test out CFD trading with a demo account
Before you sign up to the first decent brokerage firm that you find make sure to check whether or not they offer you the option to use a demo account first. What is a CFD account that you can demo? A CFD trading account that you can demo is a great way for you to practice CFD trading without actually losing any real capital investment. The broker will give you “fake money” to make CFD trades with. As such, you can learn more quickly and practice a few strategies that you may have in mind without any risk whatsoever.
Always use stop-loss orders
This is easily the most important tip we can give you when it comes to CFD trading. As we mentioned before, CFD trading can be lucrative but it can be equally risky in terms of your losses. Because your trade can lose you large sums of money it is imperative that you implement a stop-loss order before executing your trade. A stop-loss order will exit the trade for you after a certain limit that you have set has been reached. This way, you can limit your losses greatly if a CFD price point plummets in a short space of time.
Manage your risk exposure
While trading on margin can be used to great effect it can also be devastating to your capital investment and then some. So, it’s best to manage your risk by not taking on too much leverage if it can be helped. Just because you can enter a trade with much higher exposure does not mean you should. Higher exposure also means the risk of bigger losses so keep that in mind when entering your buy positions. Check out some of our trading guides to learn more about managing your risk exposure.
Advantages Of CFD Trading – What Is CFD Trading Going To Do For You?
People who ask “what is CFD trading?” generally follow that question by asking what some of the advantages are. CFD trading can be an exciting way for you to take your trading to the next level. And while there may be some risks involved, it can serve you in very good stead. Here are a couple of the advantages of CFD trading:
Lower trading fees: UK residents will find that CFD trading fees are lower than elsewhere in the world because you won’t have to pay stamp duty like you otherwise might for stock trading.
Smaller trade amounts: As you don’t actually own the underlying asset with a CFD you can make trades in much smaller amounts. For example, you don’t need to buy the full value of a share from a bigger company. CFDs provide much more flexibility in that way.
Using leverage to your advantage: We have touched on the risk of leverage in CFD trading but it can be an excellent tool when used properly. Keep the amount of leverage you use to a reasonable amount and it can turn a small trade into a much bigger profit.
Going short: CFD trading is one of the few trading options that allow you to go short with your trade. Going short can be a lot easier than going long if you know what to look out for.
Diversity of financial markets: CFD trading gives you access to a number of different financial markets like commodities, cryptocurrencies, stocks and many more. This is due to the derivative nature of CFD trading.
Risks of CFD Trading – Keep These In Mind
As we have touched on, CFDs can be a volatile investment if you don’t stop on top of your game and implement things like stop-loss orders and manage your risk. With that being said here are are some of the main risks of CFD trading:
Magnified losses: CFDs can help you skyrocket in terms of your trade profits but it can do exactly the same in the opposite direction. CFD losses are magnified if you are not careful with the amo0unt of leverage you take on. Even the smallest price point movement in the wrong direction can spell disaster if you’re not careful.
No honour amongst thieves: You need to be careful about some of the brokers that you may want to use when it comes to CFD trading. As CFD trading is the purchasing and selling of contracts between two parties you can’t always trust that the other party who needs to payout is going to hold up their end of the bargain. Our broker reviews can help you to simplify this risk by giving you a detailed look at their reputation and security.
Slippage: Slippage is when you are about to execute a buy order on a certain market and then the price of that market changes while you are still busy concluding your buy position. This is not very common but it can and does happen. This means you won’t be able to execute a lot of your trades as they will now be out of data in terms of their pricing.
Conclusion – What Is CFD In Trading? Now You Know!
Hopefully, you can now answer the question “What is CFD trading?” with more confidence. CFD trading can be an exciting endeavour. It’s a form of trading that gives you access to a number of different markets while still being able to execute more affordable trades than if you actually had to own the underlying asset. The opportunity for massive profit is certainly evident.
With that being said, we cannot stress enough that the risks of CFD trading are equal to that of the advantages. This is especially true if you are going to trade on margin with significant leverage in place. Always make sure that you implement a stop-loss order on your trade position so that you can mitigate any major losses that you may have sustained. Aside from that, turn CFD trading to your advantage by keeping our expert tips in mind when you try this mode of trading out yourself. Check out our daytrading guide for more advice on how to use a new trading strategy or learn how to fully answer the question “what is a lot?”
What Is CFD Trading? FAQ
📈What is CFD trading?
Many newcomers to trading in the UK find themselves asking “what is CFD trading?” At Betting.co.uk we want to clear up the confusion, as we give you a detailed analysis of what CFDs are and how you can use them to your advantage. We even give you a detailed real-world example of purchasing CFDs on margin with our guide.
🔒Are CFDs safe to buy and sell?
CFDs can be tricky to understand and can be even trickier to navigate. That is why our guide will help you to better understand how you can safely buy and sell CFDs without sustaining any severe losses to your overall capital.
💰What are some of the costs involved with CFD trading?
Just like every other financial instrument available on a brokerage platform you are likely to run into some additional costs when conducting your trades. As such, our guide has put together some of the most important of these costs for you to bear in mind when you go forward with your own CFD trades.
❓What is a CFD stock?
Our CFD trading guide will teach you all you need to know about CFDs. You will be able to answer the question “what is a CFD stock?” in no time at all. We also give you answers to questions like “what does CFD stand for?” and “what is a CFD account?”