What is CFD trading
& how does it work?
DEFINITION
Contract for difference trading
A contract for difference (CFD) trade is where you speculate on whether the price of a market will increase or decrease in the short-term. If you’re correct, your profits are determined by the price difference between your opening and closing trades. This price movement also determines how much money you lose if you turn out to be wrong.
It’s unsurprising that CFD trading is popular, as you don’t need to own the thing you’re trading on. For example, you could trade on the movement of Apple’s stock price without having to physically buy the shares. This lets you trade on margin, meaning that it requires less financial commitment from you. The fact that you are trading on margin also makes it easy to speculate on falling markets as well as rising ones. So, you can look to profit from a drop in the price of a share, stock index or commodity.
The way CFD trading works means it can be tempting to overtrade. The danger is that losses can be magnified significantly compared to the amount of money you need to open the trade. What’s more, you have no say in the currency you’re trading in, which may result in additional costs and complications.
For these reasons, we think CFD trading is better for experienced traders, rather than those just starting out on their trading journey.
CFD trading - Quick links:
Is CFD trading right for you?
Before you dive straight in, we want to make sure you know what’s what. If you’d like to know more about CFD trading, let us explain everything you need to know and then you can then make that decision for yourself.
If you want a flying start in trading, we think you’d be a perfect fit for Trade Nation. We’re all about helping beginners get to grips with the mechanics of trading. We also work hard to get rid of the complex jargon to make it easier to understand.
In addition, why not, try our free Trading Simulator? It allows you to practice trading and learn the essentials along the way with no risk. Ideal for beginners, it’s free and there’s no login required.
Things you might hear CFD traders say
“Going long” & “going short”
Going long means you buy CFDs as you believe prices will rise.
Going short is the opposite: you sell CFDs with the expectation that prices will fall.
How does CFD trading work?
Every contract has a sell price and buy price, which are respectively slightly lower and higher than the current market price. The difference between the sell and buy prices is called the spread, and this reflects how much it will cost you to make the trade.
If you reckon prices on a market are going to rise, you buy a number of CFD contracts (also called units). On the flip side, you sell these contracts if you think prices will fall. It’s possible to trade CFDs on lots of financial markets like commodities, stock indices, forex, and shares.
There are no fixed expiry dates on CFD trades. So in order to close your position, you have to place a trade in the opposite direction to the way you opened it. For example, if you bought 500 contracts initially, then you would close this position by selling them. It’s also worth noting that as you are trading on margin, you will have to pay interest every time you keep your trade open overnight.
EXAMPLE
Let’s look at a CFD trade on the US 500 index
In this example, the CFD provider has stated that 1 CFD is worth $1 per point, or pip.
- If you bought or sold 1 CFD on the US 500, you would make or lose $1 for every point/pip the index moves.
In this example, the sell and buy prices on the US 500 are 4,251.0 - 4,251.5.
- You believe prices are going to rise and you decide to buy (or go long) 2 CFDs at 4,251.5.
The total value of your trade is calculated by multiplying the price at which you have traded, by the number of $ per pip you have bought:
- 4251.5 x $2 = $8,503
The initial margin requirement for this trade (the minimum amount you must hold in your account to make this trade) is 5% of the trade value. 5% of $8,503 is $425.15, so this is what you need in your account to make the trade.
How a trade might play out
A WINNING CFD TRADE
You're correct and prices do increase. You close your position when the US 500 quote is 4,305.0 – 4.305.5 selling 2 CFDs for 4,305.0
To calculate your profit, you take the difference between your opening and closing prices, and then multiply by the number of CFDs you traded..
4,305.0 - 4,251.5 = 53.5 points
53.5 x 2 CFDs = $107.00
A LOSING CFD TRADE
Unfortunately, the market has moved against you and you decide to sell 2 CFDs to close your position.
Now the US 500 quote is 4,188.0 – 4,188.5 and your loss is calculated like this:
4,188.0 - 4,251.5 = -63.5 points
-63.5 x 2 CFDs = -$127.00
How a trade might play out
A WINNING CFD TRADE
A LOSING CFD TRADE
You're correct and prices do increase. You close your position when the US 500 quote is 4,305.0 – 4.305.5 selling 2 CFDs for 4,305.0
To calculate your profit, you take the difference between your opening and closing prices, and then multiply by the number of CFDs you traded..
Unfortunately, the market has moved against you and you decide to sell 2 CFDs to close your position.
Now the US 500 quote is 4,188.0 – 4,188.5 and your loss is calculated like this:
4,305.0 - 4,251.5 = 53.5 points
53.5 x 2 CFDs = $107.00
4,188.0 - 4,251.5 = -63.5 points
-63.5 x 2 CFDs = -$127.00
This sounds a bit like spread trading, doesn’t it?
CFD trading involves a spread, making it quite like spread trading which is what we also offer here at Trade Nation. Both CFDs and spread trades allow you to speculate on financial markets, but spread trading is arguably the most straightforward way to do this.
CFD vs spread trading in brief
With CFDs, the currency you trade in depends on the specific market. If you normally use GBP but the trade you want to make is valued in USD, then your profit or loss will be in USD too. You can see this in the example above. The US 500 is valued and traded in US dollars. So, you’ll need to consider the impact this could have on how much you could win or lose. Currency exchanges will be involved too, adding to your overall dealing costs.
Spread trading, on the other hand, allows you to deal in your preferred currency, so you always know where you stand. You can also choose the amount per point yourself, given certain minimum sizes. This gives you considerably more control over how you trade. It also makes it much easier to calculate your profits or losses.
With CFD trading, the amount per point is decided by the provider.
For example, the provider could say 1 CFD is worth $10 per pip, with a pip being worth 1 full US 500 point, but they may also say 0.1 of a point is a pip.
A straightforward way to trade CFDs, free from hidden and unfair charges
There’s a much better way to trade. What if we said you could avoid these added expenses and know all the fees up front?
Here at Trade Nation, we’re always completely transparent about charges, so you’ll never be taken by surprise. And, as we offer spread trading, you can speculate on the markets in a currency of your choice. Plus, all our spreads are fixed, which means your transaction rates won’t change unexpectedly.
If you want a straightforward way to trade free from hidden and unfair charges, why not join the Trade Nation community? We’re all about making trading honest and easy to understand, and we’re with you every step of the way!
3 REASONS FOR EXPERIENCED TRADERS TO TRADE CFDS WITH TRADE NATION
1. You can hedge against declines
CFD traders can hedge against declines in their share portfolio by short selling CFDs against the securities they physically hold. In this way, they can protect themselves from falling prices without incurring the costs, and possible tax implications, of closing out their physical shares.
2. CFD trading is leveraged
This means you only have to put down a small percentage of the underlying value of a trade to control all of it. This increases your trading power.
3. CFDs allow you to trade multiple asset classes from one account
A Trade Nation CFD account provides access to well over a thousand different markets from a single account. This means you can centralise your speculative and hedging activity. Running your own account from one platform, without having to instruct a broker to act on your behalf, and monitoring market movements in real time, are all major advantages of having a CFD account with Trade Nation.
FROM DAVID, SENIOR MARKET ANALYST
The final word on CFD trading
CFDs and spread trading are both very popular methods of speculating on financial markets. To understand CFD trading, it's useful to learn how it differs from spread trading. Watch and find out which one might be right for you.