What is a CFD in Trading? Understanding Contract for Differences

Several trading strategies in the world of trading suit different traders with unique financial goals and risk appetites. Some of these techniques are highly technical, while others are easy. It depends on the traders which technique they choose and then implement to make their way towards profit. The most common trading strategies are those that require minimal work and offer an acceptable profit. 

One interesting trading strategy is CFD trading, also known as contract for difference trading. This is a very unique strategy, as traders who trade an asset do not directly own it but only make profits by speculating on its price differences. This type of trading strategy works best in short-term trading and in volatile markets. There are a few risks and benefits involved with this type of trading, and in this article, we will provide you with everything that you need to understand about CFD trading and more. 

What is CFD Trading?

Contracts for differences, or CFDS, are a fascinating type of trading strategy. In CFDs, traders speculate on price differences and make a profit without actually owning the underlying asset. This means that without owning the asset, traders can experience the market and its fluctuations. This strategy is extremely capital-efficient and is widely available on most trading platforms worldwide. When conducting CFDs, the trader and the broker agree to exchange the difference between the asset’s opening and closing prices. Most CFD trading is conducted online, so online trading laws and regulations apply to both the trader and the platform. 

Simply put, traders who conduct CFD trading speculate whether the price of an asset will go up or down. If they suppose that the price will go up and it does, they make a profit. In the same way, if they speculate that the price will go down and it does, they make a profit. All of this happens between the trader and the brokerage platform, where the trader never owns any of the underlying assets. 

Even though the concept of CFD trading seems simple enough, it can get tricky very quickly. As the trader is just speculating on price movements, it depends on the discretion of the brokerage platform where all of the capital is situated. If the brokerage platform experiences technical difficulties or is under threat, the trader may also experience risk. 

How Does CFD Trading Work?

A CFD trade is conducted between two parties: the trader and the broker. The broker owns the brokerage platform through which all transactions are settled. First, the traders buy a CFD on an agreed price from the broker. This CFD can be of any asset class, such as stocks or commodities. The trader goes long if they believe the price will rise and goes short if they believe the price will fall. You can calculate your profit or loss by the following formula:

Difference in price x number of CFDs

When opening a CFD position, there are two types of margins that you should know about. An initial margin is required to open a position, and a maintenance margin is required to keep it open. If the market fluctuates and your balance in the equity account falls below a certain point, the brokerage platform can initiate a margin call, and you will have to fulfil the call; otherwise, your position might be dissolved. 

Why are CFDs Illegal in the US?

CFDs are illegal in the US because they offer high leverage, which means the margin of profit and loss fluctuates significantly. This is one of the main reasons CFD trading is illegal in the United States and a few other countries. However, CFD trading is perfectly legal and quite famous in countries like the United Kingdom, Canada, Australia, and most European countries. 

Is CFD Trading Like Gambling?

Not really. CFD trading is a strategy widely used in trading to gain profits and access broader markets that may not be possible with traditional trading. Gambling, on the other hand, is a game of chance whose outcome largely depends on luck or random events. 

Is CFD Trading Good for Beginners?

CFD trading is an excellent strategy to implement in trading if the traders understand it deeply. For beginner traders looking to get started in CFD trading, we recommend using a demo account to practice and gain relevant experience. Most online trading platforms offer a demo account, a simulated environment where traders can practice trading and experience real-world market fluctuations without using any real capital. This is most useful for traders new to the trading world who want hands-on experience. 

Contract for Differences (CFD): Overview and Examples

We know that in contracts for differences (CFD trading), traders speculate on price differences and make a profit without actually owning the underlying asset. This means that the assets may be located on the north or south pole; a person sitting on the equator can make a profit from the price difference of the asset without actually owning it. This is a breakthrough in the trading world as it has opened great doors for global trading and profit-making. 

A significant example of CFD trading is oil trading. Generally, when oil is traded, it is traded in terms of barrels. The oil market is highly profitable and probably one of the most sought-after markets in the world. Before CFD trading, if someone wanted to trade oil, they would need to physically purchase barrels of oil from anywhere in the world and transport them to their location. This is not a very trade-friendly idea.

As CFD trading offers price speculation without owning the asset, anyone can enter the oil market, speculate on whether the price will go up or down, and potentially make a profit without ever needing to move a single barrel of oil. This is the power of CFD trading, and it has revolutionised the trading world. 

Everything You Need to Know About CFDs

Here is everything that you need to know about CFD trading:

Trading Costs

Each time you trade on an online platform, the brokerage platform has some sort of charges. These charges may be commission fees, which is how the platform makes its profit, or they may be spreads, which is the difference between the ask price and the bid price of the CFD. In any case, each time you do business with a platform, you will have to pay some sort of fees. Some platforms offer advanced trading features and tools for a monthly premium. 

Financing Charges

We know that CFD trades are primarily leveraged positions. This means you are working with a loaned amount. Financing charges are the fees that you pay on loans. It depends on the brokerage platform how much they charge you and how often they charge you. To keep your position afloat, traders must pay these financing charges regularly. 

Rollover Fees 

CFD contracts do not generally expire, but if they are based on commodities, they might come with an expiration date. So, if that expiration date comes and you still haven’t dissolved your position, the platform will charge you a rollover fee, which is the fee to convert your expired contract to a new and active one. 

Steps to Open a Trading Account

As a beginner trader, trading can be easy if you know where to start. Following is a step-by-step procedure you to follow for getting started with trading:

Step 1: Set Up Trading Account

The first step is to set up a trading account. Many great platforms are available today, but each has something unique. Each platform has associated fees, commissions, features, and security regulations. Do thorough research before settling on a platform. After selecting a brokerage platform, set up your account and provide accurate personal information. Once the platform has everything it needs, you will get an email of your account confirmation and activation. 

Step 2: Learn to Use the Software/Platform and Tools 

Before jumping into trading, it’s best to learn how to use the platform and its tools. This will not only help you have a smooth trading experience but also help you make logical and profitable decisions. Familiarise yourself with the platform’s interface and features, such as charting tools, technical indicators, and market data feeds. Most platforms also offer demo accounts where you can simulate trading without using or risking real money. 

Step 3: Choose the Companies for the Trade

After thorough research, select a company that aligns with your trading goals, interests, and risk tolerance. Try to understand the driving factors behind these markets and their prices. Pick a few companies at the start and keep your research focused. This will help you make an informed choice. 

Step 4: Develop a Trading Plan

A trading plan is one of the most essential steps in trading. Start by outlining your goals for the trade and your risk tolerance, and think about your preferred trading style. Your trading plan and style will be refined over time, but it’s essential to learn from your mistakes and continue learning and researching. Focus on your strengths and develop a well-defined strategy that will help you stay disciplined. 

Step 5: Execute Your First Trade

Once you feel comfortable with your knowledge, the selected company, and the platform, execute your first trade. Deploy risk mitigation strategies to minimise loss and monitor your trade closely. Use stop-loss orders, position sizing, and portfolio diversification to avoid mishaps.

Risks and Benefits of CFD Trading

CFD trading is a lucrative trading strategy, and like any other trading strategy, it has both benefits and risks. 

Risks of CFD Trading

The following are the risks involved with CFD Trading. 

Margin Calls 

One of the most significant risks of CFD trading is your broker issuing margin calls due to market fluctuations. In such cases, you will have to add funds to your equity account promptly. In case you don’t, your position might be instantly liquidated. 

Counterparty Risk 

As CFD trades are done via brokerage platforms. If the platform experiences any issues, such as technical problems, outages, or downtime, you and your capital will be directly affected. 

Significant Losses Due to Market Fluctuations 

The basis of CFD trading is speculative trading on price fluctuations, but what happens when those fluctuations are more extreme than you anticipated? This is why CFD trading is highly risky and can result in significant losses quickly. 

Unlicensed Brokers

Another critical thing to consider is that CFD trading lacks regulation. Trading with an unlicensed broker and being scammed is a common fate, and one where you might not get help or assistance from the authorities. Therefore, whenever you choose a brokerage platform, make sure it is fully licensed to conduct the activities it claims to offer. 

Benefits of CFD Trading

The following are the benefits of CFD trading:

Flexibility 

Contract for difference trading strategy offers flexibility in trading, as anyone can use this strategy to their benefit and make a profit. Also, this strategy requires a minimum amount of upfront costs, which works well and is in favour of many traders. 

Access to Global Markets

CFD trading opens the horizons of various global markets for traders. A simple example is trading commodities. When you trade in oil, physical quantities of oil are moved from one place to another. This is one reason why many traders avoid this extremely lucrative trading class. However, if you conduct a CFD trade for oil, you can speculate on its price without actually owning any physical barrels of oil. You would pay no stamp duties or go through the ownership paperwork.

In conclusion, CFD trading or contract for difference trading, is an interesting trading strategy that allows traders to speculate on price movements and make a profit without actually owning the underlying asset. This type of trading is legal and very famous in countries like the United Kingdom, Canada, Australia, and most European countries. However, it is illegal in the United States and a few other countries due to the risks involved. CFD trading can be conducted via online brokerage platforms and involves a few fees. 

For beginner traders looking to get started in CFD trading, we recommend using a demo account to practice and gain relevant experience. Most online trading platforms offer a demo account, a simulated environment where traders can practice trading and experience real-world market fluctuations without using any real capital. This is most useful for traders new to the trading world who want hands-on experience. 

FAQs

Is CFD Trading Profitable for Beginner Traders?

There is no definitive answer to that, as any trade can be profitable if done right. For beginner traders, it can be a little tricky at first, as there is a lot of information to take in and process. So, whether it is CFD trading or any other strategy, experience matters the most. 

Which Platforms Allow CFD Trading?

Several platforms allow CFD trading, including PuPrime, MetaTrader 5, eToro, Pepperstone, and more. The choice of trading platform depends mainly on the trader and their preferences. Ensure that the platform you choose has a license to conduct the advertised trades. 

What Asset Classes Can Be Traded as CFDs?

The asset classes that can be traded as CFDs include ETFs, commodities, and stock indices. It depends on the trader now which asset class they want to trade using the CFD trading strategy and make a profit.