Contract for difference (CFDs) are complex financial instruments that allow traders to speculate on the price movement of an underlying asset. CFDs have become increasingly popular in recent years due to their flexibility, leverage, and broad market access. This comprehensive guide will provide an in-depth overview of contracts for difference, how they work, risks and benefits, trading strategies, and tips for getting started.
Introduction to CFDs
A contract for difference (CFD) is a financial derivative product that gives traders exposure to price movements in an underlying asset without owning the asset itself. The underlying asset can be a stock, currency, commodity, index, cryptocurrency, or any other tradable instrument.
When you trade CFDs, you enter into an agreement with your broker to exchange the difference in price of the underlying asset from when the contract is opened to when it is closed. If you think the price will rise, you go long and if you think it will fall, you go short.
For example, if you open a CFD position on Apple stock when it is trading at $150 per share, and the price rises to $160 when you close the trade, your profit will be the $10 difference. However, if the price falls to $140 instead, you would incur a $10 loss.
Key Features of CFDs
Here are some of the key features and benefits of trading contracts for difference:
- Leverage – CFD brokers offer high leverage that can multiply your profits but also losses. Leverage of 100:1 is common.
- Speculation – CFDs allow you to speculate on price movements without owning the asset. You can profit whether markets rise or fall.
- Flexibility – Trade CFDs on thousands of global markets including shares, forex, indices, commodities, and more.
- Risk management – Tools like guaranteed stops and negative balance protection to manage risk.
- Easy access – Open a CFD trading account quickly online and start trading in minutes. Minimum capital requirements are low.
- Short selling – Sell CFDs to profit from falling prices by going short. This allows for strategies like hedging.
Overall, CFDs provide traders with all the benefits of trading financial markets while avoiding the complexities and costs of traditional trading methods. However, leverage also amplifies losses, so knowledge of risk management is essential.
How Do CFDs Work?
CFDs are an agreement between a client and broker to exchange the difference in the price of an underlying asset from the time the contract is opened to when it is closed. Here is a step-by-step overview of how CFD trading works:
- Choose an asset – Select from thousands of global markets including shares, indices, commodities, forex pairs, cryptocurrencies, bonds, and interest rates.
- Determine position size – Decide the number of CFD units you want to buy or sell based on your analysis of the market. Position size depends on account balance, leverage, and risk appetite.
- Open position – Buy (go long) if you think prices will rise or sell (go short) if you think they will fall. This will create an open CFD position.
- Monitor price movement – Track the live price of the underlying asset as your position gains or loses value based on market fluctuations.
- Adjust stop loss/take profit – Use these risk management orders to lock in profits or limit losses. Stop loss exits position if price moves against you by a preset amount.
- Close position – You close the CFD trade by buying back the units if you initially sold, or selling if you originally bought. Your profit or loss will be the difference between the closing and opening prices.
- Rollover charges – For longer term trades held overnight, a small rollover fee is charged proportional to position size and leverage.
Once you grasp these basic steps, you will understand the complete process of making a CFD trade from start to finish.
Benefits and Risks of Trading CFDs
CFD trading offers many potential advantages but also comes with significant risks, especially due to leverage. Here are the main benefits and drawbacks:
Benefits
- Leverage – The ability to gain greater exposure with only a small amount of capital can multiply profits.
- Diversification – CFDs allow you to diversify across thousands of global markets.
- Short selling – Sell CFDs to potentially profit from falling asset prices.
- Low costs – No commissions and low financing rates compared to other derivatives.
- Risk management – Built-in tools like guaranteed stops and negative balance protection.
- Limited risk – Losses cannot exceed deposited funds thanks to leverage limits and negative balance protection.
Risks
- Leverage risk – While leverage can amplify profits, it can also magnify losses if the market moves against you.
- Counterparty risk – There is risk of broker insolvency since they are the counterparty to your trades. Use regulated brokers only.
- Funding costs – Financing costs can accumulate, especially for long-term trades held overnight.
- Gapping risk – Sudden price jumps can lead to slippage on entry and exit. Use guaranteed stops.
- Volatility – CFD pricing reflects the underlying asset volatility that can generate rapid price swings.
- Complexity – CFDs are complex products that require knowledge and experience to trade profitably.
Overall, CFDs should only be traded by knowledgeable traders who practice sound risk and money management given the risks involved.
CFD Trading Strategies
There are countless CFD trading strategies that traders utilize to try and profit from price movements in the underlying market. Here are some of the most common CFD trading strategies:
Trend Trading
Trend trading aims to identify and profit from an asset trading in a strong upward or downward price trend. Technical indicators like moving averages are used to determine trend direction. Once the trend is confirmed, traders open long or short positions accordingly expecting the trend to continue.
Range Trading
With range trading, the goal is to buy near support and sell near resistance when an asset trades sideways within a well-defined price range. The time frame traded can vary from short-term ranges to longer-term trading ranges that develop over weeks or months.
News Trading
This strategy revolves around trading market-moving news events and economic data releases. Traders will buy or sell CFDs immediately after major news events in anticipation of an explosive price move higher or lower depending on how the news is received.
Hedging
Investors can hedge existing portfolio assets like stocks or indices by short selling related CFDs as a form of risk management. For example, if you own shares trading at $50, you could short sell the equivalent value in CFDs as protection.
Scalping
Scalpers aim to profit from small price movements using leverage. Trades are typically held for very short periods from minutes to seconds, so this strategy requires quick execution and low spreads. Tight stops are used to lock in small gains and limit risk.
Getting Started with CFD Trading
If you are new to CFDs, follow these steps to start trading properly:
- Educate yourself – Learn about CFD mechanics, risks, and strategies. Gain an understanding of technical and fundamental analysis.
- Find a regulated broker – Open an account with a reputable, regulated CFD broker that provides negative balance protection.
- Start with a demo account – First trade with virtual funds on a demo platform to get experience without risk.
- Develop a trading plan – Create a detailed trading plan and risk management rules that suit your style and risk tolerance.
- Start small – Use small position sizes and conservative leverage at first. Only invest capital you can afford to lose.
- Analyze performance – Review your trading activity, including wins, losses, and emotions. Identify strengths and areas for improvement.
- Continually learn and adjust – Commit to ongoing education and be willing to adapt your trading plan to improve results. Patience and discipline are critical.
With the proper preparation and mindset, CFD trading can offer immense potential. However, success requires extensive research, practice, and commitment to mastering the craft of trading.
Frequently Asked Questions
Here are answers to some of the most common questions about contracts for difference:
Are CFDs regulated?
Yes, CFD providers operating in the U.S., UK, EU, Australia and other major jurisdictions are regulated. Always verify a broker is licensed by a top-tier financial authority.
What assets can I trade with CFDs?
CFDs are available on thousands of global markets including shares, indices, forex, commodities, cryptocurrencies, bonds, and interest rates. Offerings differ between brokers.
How does CFD pricing work?
CFD pricing mirrors the pricing of the underlying asset, adjusted for any applicable fees and costs. Prices update by the second during trading hours as the underlying market moves.
What is CFD leverage and how does it work?
Leverage allows you to gain greater exposure to the underlying market so your deposit can control a larger position size. For example, 10:1 leverage means your capital is multiplied 10x.
What are the costs of CFD trading?
There are typically no commissions, and the financing charges are built into the CFD spreads and overnight rollover fees. Verify fees before opening an account.
Is CFD trading riskier than buying the asset directly?
Yes, CFDs carry more risk due to the extensive use of leverage in CFD trading accounts that can lead to magnified losses. Risk can be managed by using appropriate leverage.
Conclusion
CFDs are complex instruments that allow traders to profit from price movements in underlying global markets. While CFDs offer advantages like leverage and short selling, the risks involved mean they are not suitable for all investors.
Traders who are prepared to research CFDs extensively, learn proven strategies, practice good money management, and maintain discipline have potential to generate profits. However, losses can also accumulate rapidly with poor risk controls.
By providing a broad introduction to contracts for difference, how they work, risks and rewards, trading approaches, and tips for getting started, this complete guide aims to give you the knowledge to make informed decisions about trading CFDs.