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What is a contract for difference (CFD)?

A contract for difference (CFD) is a popular type of derivative in finance.  Derivatives are time-limited contracts that ‘derive’ their value from the market performance of an asset. This guide has everything you need to know about CFD trading explained in simple terms.

So what does CFD mean in trading? CFDs allow you to speculate on various financial markets, including stocks, indices, commodities, forex pairs, and cryptocurrencies. You never buy the assets, but trade on the rise or fall in their price, usually over a short period of time.

A CFD is a contract between a broker and a trader who agree to exchange the difference in value of an underlying security between the beginning and the end of the contract, often less than one day.

A contract for difference (CFD) is:

  • A derivative - you do not own the underlying asset
  • An agreement between you and your broker
  • Based on the change in price of the asset
  • Over a short time period

In this CFD trading guide

What are CFDs?

A contract for difference (CFD) lets you trade with just a fraction of the value of your trade, which is known as trading on margin, or leveraged trading. This allows traders to open larger positions given their initial capital. Therefore, CFD trading offers greater exposure to global financial markets.

One of the major benefits of CFD trading is that you can speculate on the asset’s price movements in either direction. You simply buy or sell a contract depending on whether you believe the asset’s price will go up or down. You open a long or a short trade accordingly.

However, you should always note that leverage trading can amplify your wins, but can also boost your losses.

Flow chart depicting the steps to start CFD trading

How does CFD trading work? 

When you open a contracts for difference (CFD) position you select the number of contracts (the trade size) you would like to buy or sell. Your profit will rise in line with each point the market moves in your favour. 

Buy

If you think the price of an asset will rise, then you would open a long (Buy) position and profit if the asset price rises in line with your expectations. 

Sell

If you think the price of an asset will fall then you would open a short (Sell) position and profit if it falls in line with your prediction.

Watch a short video below to learn how to make your first trade. 

What is a CFD account?

A contract for difference (CFD) account enables you to trade on the price difference of various underlying assets using leverage. Leverage means you put up only a fraction of the amount needed to trade. This is called deposit margin. You will also need to have enough in your account to cover any potential losses if trades go against you. This is called maintenance margin.

Your broker needs to know a little about you before they can offer you margin trading, so they ask you to set up a special account, proving your identity and ability to cover losses. Often you can practise trading in a demo account, but you will need to add funds to create a CFD trading account before you can trade properly.

Some regulators require that new customers pass an ‘appropriateness’ test. This often means answering some questions to demonstrate that you understand the increased risks – and not just the potential rewards – of trading on margin. It’s best to thoroughly educate yourself on how leverage and margin work before trading.

Some experienced traders set up more than one CFD account with the same broker to trade different assets or to follow alternative trading strategies.

What is a CFD account

What is leverage in CFD trading? 

When you are trading contracts for difference (CFDs), you hold a leveraged position. This means you only put down a part of the value of your trade and borrow the remainder from your broker. 

Leveraged trading is also referred to as trading on margin. A10% margin means that you have to deposit only 10% of the value of the trade you want to open. The rest is covered by your CFD provider. 

For example, if you want to place an order for $1,000 worth of Brent crude oil and your broker requires 10% of margin, you will need only $100 as the initial amount to open the trade.

Pie chart showing that a 10% margin is how much is required for leveraged trading

Spread and commission 

With CFD trading, you’re always offered two prices based on the value of the underlying instrument: the buy price (offer) and the sell price (bid). 

The price to buy will always be higher than the current underlying value and the sell price will always be lower. The difference between these prices is called the CFD spread. At Capital.com, we do not charge CFD commission on any trades made with us.

  • The Buy price (offer) is the price at which you start, or open, a long position

  • You close your position when you Sell

  • The Sell price (bid) is the price at which you open a short position

  • You close your position when you Buy

Timeline chart that depicts what CFD spread is

For example, if you expect the price of gold to increase you may want to open a position with a CFD on gold. Imagine the quoted price is $1,200/$1,205 (this is the bid/ask spread) and you buy 100 CFDs on gold (taking a long position). The size of the position taken (the contract value) is illustrated below.

Chart showing an example of a Gold CFD with a spread of $5

Now imagine that the price of gold increases as expected, the profit from this trade is illustrated below.

Chart showing an example of how the profit from trading gold CFDs can increase with the price increases of gold

How much should you invest?

CFD trading democratises the markets by providing a low entry level. Capital.com has traders who open positions worth more than $1m a time but the minimum deposit you can trade with is just $20 (€20, £20, 100PLN).

If you are using wire transfer the minimum deposit is €250.

You can open an account for free and practise in demo mode. Capital.com is a flexible and scalable solution for everyone, regardless of your risk appetite, experience or the amount of money you have to trade.

CFD trading is considered a cost-effective way of entering the financial markets. With some brokers, CFD costs include a commission for trading various financial assets, however, Capital.com doesn’t take commissions for opening and closing trades, for deposits or withdrawals. 

The major CFD cost is the spread – the difference between the buy and sell price at the time you trade. There is an additional charge of an overnight fee, which is taken if a trade is kept open overnight.

As contracts for difference are leveraged products, you can open much larger positions with a lower initial deposit than you need to buy traditional shares. For example:
 

Buying Apple CFD tradeShare trade
Sell / Buy Price135.05 / 135.10135.05 / 135.10
DealBuy at 135.10Buy at 135.10
Deal size 100 shares100 shares
Funds required to open a trade$ 2,702 = $135.10 Buy price x 100 shares x 20% margin (Margin required)$13,510 (100 shares at 135.10)
Close priceSell at 150Sell at 150
Profit$1,490
((150 - 135.10) x 100 shares = $1,490)
$1,490
(15,000 – 13,510 = $1,490)

What assets can you trade with CFDs?

You can trade CFDs on shares, indices, commodities, currencies, and cryptocurrencies. Capital.com provides access to thousands of different CFD assets across these classes, so you are only a few clicks away from trading the world’s most popular markets all in one place.

Icons depicting indices, shares, commodities, forex, and cryptocurrencies

The choice of available CFD options is constantly growing. In 2020, Capital.com significantly expanded its offering and added new markets, which will bring many new attractive trading opportunities. They include: thematic indices (Corona anti-virus index, Crypto index), futures (US crude oil, UK Brent oil), cryptocurrencies (Cardano, Polkadot), MOEX and SGX-traded stocks, etc. 

Example CFD trades: Long, short and margin trading

Contracts for difference allow you to speculate on assets’ price movements in either direction. This means you can profit not only when the market goes upwards (goes long), but also when it goes down (short) in price. 

  • If you believe the market will rise, you Buy or ‘go long’.

  • If you believe the market will fall, you Sell or ‘go short’.

When you open a CFD position, you select the number of contracts you would like to trade (buy or sell) and your profit will rise in line with each point the market moves in your favour. 

Going long example

You think Apple shares are going to appreciate and you want to open a long CFD position to profit from this opportunity. 

You purchase 100 CFDs on Apple shares at $160 a share, so the total value of the trade will be $16,000. If Apple appreciates to $170, you make $10 a share, which is a $1,000 profit. 

The steps in the illustration below are:

  1. 165  You start looking at the market

  2. 160 You see the price fall, and decide to open your trade (Buy the CFDs).

  3. 170 You see the price of your CFD rise, and close your trade (Sell the CFDs), making a profit of $10

Going short example

For example, you think that the Apple price will depreciate, and you want to profit from this movement. You can open a short CFD position (known as short-selling) and profit from a falling market. 

This time, let’s say, you decide to sell 100 CFDs on Apple at $170 per share, which then falls to $160 per share. You will have made a profit of $1,000, or $10 per share. 

The steps in the illustration below are:

  1. 165 You start looking at the market

  2. 170 You see the price of your CFD rise, and open your trade (Sell the CFDs), making a profit of $10

  3. 160 You see the price fall, and decide to close your trade (Buy the CFDs).

Graph showing an example of the profit possible from a long CFD and then a short CFD

Margin trading example

What is margin CFD trading? Leveraged trading is also referred to as margin trading. This is because the funds required to open and maintain a position – known as the CFD margin – are only a part of the total trade size. 

There are two types of margin you should be familiar with when trading CFDs. 

  1. Deposit margin: This Is the amount required to open a position

  2. Maintenance margin: This may be required if your trade starts making losses that are not covered by the deposit margin or additional funds held in your account. 

The margin required depends on the deal offered by your broker and varies between asset classes and within different regulated areas.

For example, you buy 100 CFDs on Apple at a price of $135.10. Your initial outlay is $2,702 ($135.10 Buy price x 100 shares x 20% margin). The value of Apple stock moves to 150, and you decide to sell at this value – a 14.9  point increase. 

The profit you have made from this trade is $1,490, calculated by multiplying the point increase with the number of contracts purchased (14.9pt increase x 100 shares = $1,490). 

 CFD tradeShare trade
Sell / Buy Price135.05 / 135.10135.05 / 135.10
DealBuy at 135.10Buy at 135.10
Funds available (Balance)$ 3,000$3,000
Leverage5:11:1
Deal size100 shares20 shares
Funds required to open a trade$ 2,702 = $135.10 Buy price x 100 shares x 20% margin$ 2,702 = $135.10 Buy price x 20 shares
Close priceSell 100 shares at 150Sell 20 shares at 150
Profit$1,490
(14.9pt increase x 100 shares = $1,490)
$298
(14.9pt increase x 20 shares = $298)

Profit and loss

Once you’ve spotted a trading opportunity in the market and you’re ready to trade, open a position in accordance with where you think the market will go. From this point, your CFD profits or losses will move in line with the underlying asset price in real time. 

You'll be able to monitor all positions that you have opened within the platform as well as close the positions when you want. 

Profit and loss are easily calculated: you just multiply the number of contracts you hold by the difference in price. Your profit to loss ratio, often abbreviated to P&L, can be defined using the following formula:

P&L = number of CFDs x (closing price – opening price)

For example, if you were to purchase 1,000 CFDs on Aviva at 400p per share and sell them at 450p per share your profit would be £500. This is illustrated below. 

Chart showing buying and selling CFDs on margin to make a $500 profit
 

What is the contract length of CFDs?

Most CFD trades have no fixed expiry date, meaning that the CFD contract length is unlimited. A trade is closed only when placed in the opposite direction, i.e. you can close a buy trade on 100 CFDs on silver only by selling these CFDs.

However, If you want to keep your daily CFD trade open after the cut-off time (usually 10pm UK time, but can vary for international markets), you will be charged an overnight funding fee. Capital.com only charges overnight fees on the leveraged portion of the trade – not on the total trade size.

Advanced strategies for risk management using CFDs

CFDs are complex instruments and trading them entails a high degree of risk. The value of a trade can rise and fall, so you may suffer losses if the market moves against your expectations. Therefore, CFD risk management is one of the crucial points to consider and implement in your trading practice.

Once you have your account set up and devised a trading plan, it is important to determine how much you are willing to risk to formulate an appropriate CFD risk management strategy. If you are risk-averse, then you will be looking for opportunities with lower risk-to-reward (R-R) ratios

For instance, if you are looking for slow and steady growth, asset classes with higher volatility should form a proportionally small part of your portfolio. It is strongly recommended to diversify across all asset classes to increase the likelihood of attractive trading opportunities, as well as to mitigate risk. 

Stops-loss and take-profit

You should consider setting up limit orders to automatically close out a position at a given profit level so you do not have to watch the market constantly. Take-profit orders reduce the likelihood of you holding on to a winning trade for too long and seeing the price fall again. Trade with your head and not your heart.

Similarly, you can place stop-losses to mitigate CFD risks and restrict your potential losses. A stop-loss is the point at which a position is automatically closed out if the price of the asset drops below the amount you decide, in advance, that you are prepared to lose. 

Stops and limits are crucial risk management tools and you are strongly advised to use them.

Negative balance protection and margin closeout 

If you make a trade and it is not going how you expected, Capital.com protects you from losing more than you first invested. In order to keep positions open, a trader must meet the maintenance margin requirement; the minimum value of funds needed to be kept in a margin account to cover any credit risks while trading. 

The value maintained in a margin account acts as collateral for credit. If your exposure is about to exceed the maintenance margin requirement, Capital.com notifies you via a ‘margin call’. This is where you will either need to top up your balance or close some of your positions. 

If you do not act and the closeout level is reached, your positions will be automatically closed. 

With negative balance protection, you can be sure that your account balance will never drop below zero. If a market suddenly moves against you, Capital.com platform can close the affected position to protect you.

Remember to employ risk management techniques in every trade and be even more cautious when trading CFDs on assets that have a history of being highly volatile like cryptocurrencies. Consider whether you understand how CFDs work and whether you can afford the risks that come with CFD trading.

Hedging

Hedging in trading is a crucial risk management strategy used by experienced traders. 

A hedge is a risk management technique used to reduce losses. You hedge to protect your profit, especially in times of uncertainty. The idea is that if one investment goes against you, your hedge position goes in your favour.

CFD hedging provides an opportunity to protect your existing portfolio due to the fact that you can sell short by speculating on a price downtrend.

Line graph showing the relationship of an example share price and the share CFD position over time

For example, you have an existing portfolio of blue-chip shares. You want to hold them for a long time, but you feel as if the market is about to witness a short dip, and you are concerned about how this will affect the value of your portfolio.

With leveraged trading, you can short-sell the market in order to hedge against this downtrend possibility. Then, if the market slides, what you lose on your portfolio can be offset by the gain from your short hedge using CFDs. If the market rises, then you will lose on your hedge but gain on your portfolio.

Why trade with Capital.com?

As a technologically advanced CFD platform, offering the ultimate trading experience, Capital.com has many positive features, which can add to traders’ experience.

  • Advanced AI technology at its core: A Facebook-like News Feed provides users with personalised and unique content depending on your preferences. If a trader makes decisions based on biases, the innovative News Feed offers a range of materials to put you back on the right track. The neural network analyses in-app behaviour and recommends videos, articles and news to polish your investment strategy.
  • Trading on margin: Providing trading on margin (up to 200:1 leverage), Capital.com gives you access to financial markets with the help of CFDs.
  • Trading the difference: When trading CFDs, you don’t buy the underlying asset itself, meaning you are not tied to it. You only speculate on the rise or fall of the asset price. When CFD trading you employ the same strategies as you would in traditional markets, with the exception that you can short-sell with CFDs. A CFD investor can go short or long, set stop and limit losses and apply trading scenarios that align with their objectives.
  • All-round trading analysis: The browser-based platform allows traders to shape their own market analysis and forecasts with sleek technical indicators. Capital.com provides live market updates and various chart formats, available on desktop, iOS, and Android.
  • Focus on safety: Capital.com puts a special emphasis on safety. Licensed by the FCA, CySEC and NBRB, it complies with all regulations and ensures that its clients’ data security comes first. The company allows you to withdraw money 24/7 and keeps traders’ funds in segregated bank accounts.

Why trade with Capital.com

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