| Updated: December 11, 2024If you have ever opened the website of a brokerage company, you inevitably have noticed many of these give clients the option to trade with the so-called contracts for difference (CFDs). This type of derivative is commonly preferred by veteran traders accustomed to trading on margin with leverage because it offers numerous advantages.
Our detailed guide tells you anything you may want to know about trading with CFDs. We explain how this type of derivative instrument works, how it is regulated, what markets it is available for, and some of the key concepts you need to understand before you choose a CFD broker. Also covered are the advantages and disadvantages of the instrument.
Below you can find the best platforms for CFD trading:
- $0 Min Deposit
- Demo Account
- Hedging
- Scalping
- $0 Min Deposit
- Demo Account
- Hedging
- Scalping
- $100 Min Deposit
- Demo Account
- Hedging
- Scalping
- $5 Min Deposit
- Demo Account
- Hedging
- Scalping
- $10 Min Deposit
- Demo Account
- Hedging
- Scalping
- $100 Min Deposit
- Demo Account
- Hedging
- Scalping
- $0 Min Deposit
- Demo Account
- Hedging
- Scalping
- $500 Min Deposit
- Demo Account
- Hedging
- Scalping
- $100 Min Deposit
- Demo Account
- Hedging
- Scalping
- $50 (AU$100) Min Deposit
- Demo Account
- Hedging
- Scalping
- $10 Min Deposit
- Demo Account
- Hedging
- Scalping
- 78% of retail investor accounts lose money when trading CFDs with this provider.
- $0 ($25 for Trustly, Visa, Mastercard) Min Deposit
- Demo Account
- Hedging
- Scalping
What Is CFD Trading?
The contract for difference (CFD) is a derivative financial instrument that enables traders to speculate on the price fluctuations of fast-moving markets such as the foreign exchange, indices, soft and hard commodities, bonds, and shares.
Traders can speculate on the rise or fall of market prices without owning any underlying assets like fiat currencies, cryptocurrencies, precious metals, physical shares in a company, natural gas, sugar or crude oil. This speculation is possible in either direction, with traders having the option to open short or long positions.
The losses or profits they realize depend on the extent to which their price-movement predictions are correct. With contracts for difference, the actual value of the underlying assets is not taken into account. Instead, only the changes in the entry and exit values of the prices are considered. In essence, this is a contract between a broker and their customer, hence the name of this instrument.
With CFDs, the trader opens a long or short position for a given number of units for their preferred market, depending on whether they think the price value of the said market will appreciate or depreciate.
When the trader believes the value of their selected market will rise, they choose to open a buy position, or go long in other words. In this case, their earnings will rise proportionately to the increase in the market price, i.e. they will earn multiples of the number of units the price has risen by.
Unfortunately, the opposite is also true. If the price of the market drops, the trader will register losses for each point by which the price moves against them. Here is a concrete example of how trading with cash CFDs works.
Suppose a trader believes the value of Brent oil will go up, so they decide to open a buy position and purchase one contract for USD/BBL at a current market price of 72.85. The Brent oil market rises by eleven points to 72.96 and the trader decides to close down their position. Every price movement of $0.01 for USD/BBL is worth $0.10. The Brent oil price has changed by 11 cents in this case, resulting in a net profit of $1.10 ($0.10 x 11 cents) for the trader.
As we said earlier, there is also the possibility of the market moving in the opposite direction, i.e. against the trader. If this happens and the price of Brent oil drops by twenty points to 72.65, for example, the trader will suffer losses of (72.85 – 72.65) x 0.10 = 20 x 0.10 = $2.00, instead. Thankfully, our hypothetical trader was watching the market closely and exited their position in time to prevent further mounting losses.
6 Key Concepts of CFD Trading
The contract for difference is a more complex and highly volatile trading instrument, which causes most unversed retail traders to part with their accounts’ balance. The instrument requires a good level of understanding or else you risk incurring significant losses. It is no surprise that CFDs are commonly preferred by seasoned traders with sufficient experience and knowledge.
These qualities enable them to make correct predictions about the price movements of different markets. If you are new to trading with this derivative, we recommend you carefully read the next sections to familiarize yourself with six key concepts of this instrument.
Short and Long Positions in CFD Trading
We previously mentioned that those who choose this instrument have the opportunity to trade in two directions, or to go long or short. Trading with CFDs mimics conventional trading in the sense that you realize profits when the value of a market appreciates. In this case, you open a CFD for a given asset, which is known as “going long”.
However, it is also possible to earn money when the market’s price diminishes, in which case the trader shortens their position. Trading on falling markets is commonly referred to as “going short”.
Here is another hypothetical example. Let’s assume a person decides to shorten the FTSE 100 index, which comprises companies like Shell, Barclays, British Petroleum, and Lloyds. The person believes the price will drop and expects the index to underperform in the forthcoming season.
They choose to go short, i.e. open a sell position in FTSE 100 at a price of 2,450. The index indeed underperforms and drops by fifty points to 2,400. This causes the trader to close their position and realize profits of $50 from the fifty-point difference in the entry and exit prices for the CFD they have purchased. Regardless of what direction you trade in, you register profits or losses once you close your open buy/sell position.
CFDs and Leverage
The contract for difference is a leveraged product, which enables traders to invest smaller amounts of money to deal with a much larger trading volume. This is known as leverage. Say a trader is interested in opening a position equal to 1,000 shares in Facebook, for example.
In the absence of leverage, this would mean they must cover the entire cost of the Facebook shares upfront. To proceed with the example, the price per share is $1, or 100 x $0.01. In a conventional situation where the person executes a traditional trade with a broker, they will have to pay them 1,000 x $1 upfront.
This would cause them to expose a total of $1,000 to risk, provided that we ignore any additional charges or commissions. If Facebook shares jump by $0.30, the price per share will increase to $1.30.
Upon closing the position, the trader would have turned a profit of $300 from their initial investment of $1,000. Of course, the opposite is also possible. The trader could have lost $300 if the market price of the Facebook shares had dropped by $0.30, which is more than one-third of their original investment.
However, this is not the case if the person decides to open a position for a leveraged product like the CFD where they will have to invest only 20% of their initial $1,000 capital, or $200. Note that these percentages may differ depending on the CFD broker you trade with and the regulatory requirements in your country of residence.
The trader would still realize a profit of $300 when the Facebook price increases to $1.30 per share but this will happen at a significantly lower cost. Provided that the share price moves in an unfavorable direction and drops by $0.30, the person would have ended up losing more than their initial balance, or $300.
Leverage is great from the perspective of professional traders because it gives them the chance to spread their capital further and gain greater market exposure. However, it is worthwhile noting that leverage is a double-edged sword because brokers calculate both your gains and losses at the full price of your CFD position.
Using leverage can considerably magnify the profits or losses CFD traders suffer, so much so that sometimes the financial hit you take may even exceed your original deposit.
CFDs and Margins
Another important concept beginner CFD traders should familiarize themselves with is that of margin. This one is closely linked to the concept of leverage. The margin represents the minimum amount traders must deposit in their balance to open and maintain a position when using a specific leverage ratio.
Trading on margin is essentially the same as borrowing money from your CFD broker to open a larger position. You will come across two types of margin when trading CFDs. First, you have an initial margin, which you must meet before you can even open a given trading position. This is basically the amount you must deposit to buy or sell a given asset with leverage.
Then, you have a maintenance margin, which is the minimum equity you must have available in your balance to keep your leveraged position open. If your balance falls below the required maintenance margin, your broker will prompt you to deposit more money by sending you what is known as a margin call. If you fail to respond to the margin call on time, the broker will automatically close down your losing leveraged position to prevent your losses from mounting further.
Spreads and Commissions for CFD Trading
When you trade with this complex instrument, your broker always offers you two prices that depend on the underlying value of your chosen market, the bid (buy) price and the ask (sell) price.
The bid price is usually lower than the ask price regardless of the type of asset one is trading, be it a commodity, a currency pair, or an index. The difference between the bid and ask price you are offered is known as the spread.
Many CFD brokers do not charge additional commissions. There is no need to because they profit from the spread built into the CFD markets. There are exceptions, of course. Brokers using the ENC pricing model offer lower “raw” spreads without adding a markup, pulling prices directly from their liquidity providers and the interbank market. They often compensate for these lower spreads by charging fixed commissions when traders open and close positions.
It is best to check beforehand the policies of your chosen CFD broker and inform yourself about potential commissions. Many brokers charge commissions for stock CFDs only.
Here is an example of how the spread works. Suppose a trader wants to open a long position for GBP/USD and the current bid price quoted by their broker is 1.2764. The ask price is 1.2766. We subtract the bid from the ask price to calculate the spread. We have a spread of 2 pips in this case (1.2766 – 1.2764 = 0.0002). If a trader goes long and buys pounds with dollars, their broker will charge them the ask price of $1.2766.
Assuming the trader shorted their position immediately by selling back their pounds to the broker for dollars, this will cost them $0.0002 per every pound sold at a bid price of $1.2764. If our hypothetical trader used mini lots (10,000 units of currency), this speculative trade would result in additional expenses of $2 ($0.0002 x 10,000) solely due to the spread.
CFD Contract Sizes
The contract size is another important concept CFD traders must acquaint themselves with before they join a brokerage website. It is based on the underlying assets you speculate with. The contract size usually mimics how the respective asset is traded on the market.
Silver, for example, is often traded in lots of 5,000 troy ounces, with a single troy ounce equaling 1.09714286 (31.1034768 grams in the metric system). Troy ounces are antiquated units borrowed from the Roman Empire but are still used today to preserve measurement standards over time and prevent problems for the current monetary system.
A CFD for silver will be equal to 5,000 troy ounces. Meanwhile, if you speculate with shares, you usually face a contract size equal to a single share of your chosen company. Thus, if you open a long position for 100 shares of Amazon, you are, in essence, entering into a contract for 100 Amazon CFDs.
Other examples of the differences in contact sizes include soft commodities like coffee, which is measured in pounds, and soybeans, which are traded in bushels. Forex CFDs are often traded in standard lots where one contract equals 100,000 units in the base currency of the forex pair. Some brokers facilitate trading in mini lots (10,000 units), micro lots (1,000 units), and cent lots (100 units).
Hedging
If you are acquainted with professional traders, you might have heard them mention hedging. This approach is implemented by many experienced investors who trade with CFDs. They use it to manage their risk and protect their existing portfolio.
Let’s assume a hypothetical trader has bought 10 shares in Netflix at a price of $910 per share, investing $9,100 in total. If the company reports a disappointing quarter and share prices drop to $860, our trader could lose $500 from their original $9,100 investment.
The trader can mitigate their risk without disposing of their shares by hedging with contracts for difference. They can profit from long positions if the market prices increase. Gaining from falling markets is also possible when a trader opens a short position and the prices start declining. Our hypothetical trader thinks the value of Netflix shares is about to depreciate and goes short with a CFD on 10 shares at the current market price of $910.
Netflix prices indeed drop from $910 to $860, causing the trader to lose $500 as their investment is now worth $8,600 only. However, the trader’s short CFD position offsets this loss because they opened it at a starting price of $910 per share, and the prices have now dropped by $50 to $150. The trader generates profits of $500 (a $50 price difference x 10 shares) from this CFD.
Hedging will spare them the hassles and the additional expenses associated with having to liquidate their stock holdings. You can also determine your stop and loss limits so that your CFD positions automatically close when they reach your preferred profit or loss level. This is another way to manage your risk when trading CFDs.
4 Common Markets for CFD Trading
One great thing about CFDs is that the instrument is available for all asset classes, including currency pairs, indices, stocks, soft and hard commodities, and even bonds. The sections below cover four of the most common options for CFD traders.
Forex CFD Trading
Many experienced investors prefer to trade currency pairs like EUR/USD via contracts for difference because this increases their exposure to the Forex market. The latter is the largest and most liquid market in the world, exceeding even the stock market in terms of trading volume.
According to data compiled by the Bank for International Settlements (BIS), the forex market recorded an impressive trading volume of over $7.5 trillion per day in 2022.
Instead of buying and selling currencies in the conventional way on the spot market, you can trade units of currencies with CFDs depending on whether you think their underlying value will appreciate or depreciate. It works quite similarly to traditional Forex trading. Trading CFDs for this instrument comes with many different benefits. For example, there is no need for you to deposit the full value of your trades.
Commodity CFDs
Another option for CFD traders is to trade commodities. There are two types of those, starting with hard commodities like natural gas, crude oil, and precious metals that are mined.
There are also soft commodities like sugar, orange juice, coffee, cocoa, wheat, corn, livestock and soy that are grown. We should also mention that many CFDs for soft commodities borrow their prices from the underlying values of the futures market.
Share CFDs
Most CFD brokers usually give their clients the option to enter into contracts for difference on the shares of some of the world’s largest companies. Both long and short positions are available for this market. One contract is normally equal to one share in a company, meaning that trading 500 shares in Netflix, for example, requires purchasing 500 contracts for difference. Some brokers facilitate trading with fractional shares, allowing clients to gain exposure to the stock market by trading less than one whole share. The trading hours coincide with those for the underlying exchange. In most cases, a commission is charged on share CFDs.
Index CFDs
Another alternative for CFD traders is to speculate on the performance of different stock markets, including some of the biggest indices in the world, such as Dow Jones, the FTSE 100 Index, Nikkei 225, the German DAX 30, Nasdaq, the Hang Seng Index, and the NYSE.
As a matter of fact, trading index CFDs is the less volatile alternative to trading individual stocks. It enables the trader to spread their risk across an entire market instead of restricting themselves to a single company.
Advantages and Disadvantages of CFD Trading
Contracts for difference are an advanced trading instrument, which can be very beneficial for seasoned traders but at the same time, very detrimental to those lacking experience and proper understanding of how it works. Let’s start with a rundown of some of the main advantages this instrument has to offer.
- The ability to trade with leverage enables you to gain greater market exposure and generate significant profits with a relatively small initial investment.
- You earn profits from the price movements of markets without having to own any underlying assets yourself.
- Costs are reduced because most markets available for CFD trading, with the exception of shares, come with no extra commissions. The costs for brokers are usually covered by the spreads built into the bid and ask prices.
- CFD traders face a huge variety of trading opportunities. Many brokers who offer such contracts provide a choice from currency, commodity, index, stocks, bonds, and treasury CFDs. This ensures speculators have a broad range of financial vehicles to operate with.
As we stressed on several occasions, this is a complex instrument often drains the entire balance of many retail traders. You should carefully examine the pitfalls below before you start your CFD trading experience.
- Remember when we said you can score huge profits with a small starting investment due to leverage. The bad news is the opposite is also true. Leverage boosts your potential for profits but it also increases your losses. As a suggestion, you can reduce your risk by setting up stops on your losses to protect your balance if the prices move against you.
- CFD trading comes with higher volatility for long-term traders. If you keep your CFD positions open for extended periods of time, this may boost your trading costs due to the overnight fees brokers charge for leveraged trades. From this perspective, sometimes it would be better to buy the underlying assets.
- Many brokers require CFD traders to pay commissions upon opening and closing their positions. This significantly reduces the potential to realize profits from small investments. It is true that conventional markets are subject to extra fees and require more capital but the spread, coupled with potential commissions, can also trim down your potential profits.
Platforms That Support CFD Trading
Many brokerages develop proprietary software, which may be considered a setback by prospective customers who are not accustomed to working with such platforms.
One viable course of action in this case would be to open a demo account with the respective broker and practice with a virtual balance until you get a proper feel of how everything works.
With that said, the majority of brokers still prefer to use the third-party platforms, developed by MetaQuotes Software. Two versions are usually offered for a free download on Mac and Windows-based computers.
The more popular but older option is the MetaTrader 4 (MT4), which many brokerage clients still prefer to use. This one was created specifically for Forex traders.
If you are looking to trade with CFDs, we suggest you use the newer MetaTrader 5 (MT5) because it was built specifically for trading instruments like CFDs, futures, and stocks. Both versions are mobile-compatible, with free native apps available at the Google Play and the Apple stores.
There are tons of great features on either platform. Both boast a user-friendly interface and offer different functionalities, including many timeframes, one-click trading, multiple languages, technical indicators, graphical objects, and automated trading. There is also a browser-based version, called WebTrader, which does not require additional software downloads.
Regulations Rundown – Who Can Trade CFDs?
One important thing to keep in mind if you are interested in CFD trading is the fact this instrument is not legal in all jurisdictions because of its high volatility. Most regulated brokers offering this service must prominently display disclaimers on their websites, warning their clients about the financial pitfalls associated with this derivative.
The regulatory requirements are country-specific. For example, under the rules enforced by the Financial Conduct Authority (FCA) in the UK, brokers are expected to carefully assess the suitability for CFD trading of each customer. Those who are not experienced or knowledgeable enough will be denied the service.
CFD trading is legal in Australia as well. However, the local financial watchdog, ASIC, labels this instrument as “detrimental” to retail customers. In August 2019, the Australian regulator went as far as to propose severe restrictions on leverage as well as on what markets locals can trade CFDs on.
On a previous occasion, ASIC drew parallels between casino gambling and contracts for difference, suggesting the former is less risky. This echoes the sentiments of American investor, philanthropist, and businessman Warren Buffett, who once described derivatives like the CFD as “a financial weapon for mass destruction”.
Trading on CFDs in Europe is regulated under the Markets in Financial Instruments Directive (MiFID). This piece of legislation enables brokers based in member states of the EU to offer speculative products to customers residing in all other countries of the Union and the European Economic Area (EEA).
Other territories where this derivative is legal include most of Canada, Japan, Singapore, the United Arab Emirates, South Africa, and New Zealand. In some places like Belgium, the provision of specific CFDs is prohibited.
Maximum leverage requirements vary depending on local regulations. Hong Kong and the United States are some of the jurisdictions where CFD trading is completely outlawed.