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What is CFD Trading and What Does CFD Mean?

19 minutes
intermediate
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Cristian Cochintu
Cristian Cochintu
11 August 2023

Trading CFDs allows you to speculate on shares, indices, cryptos, commodities, forex, and more. Learn what is CFD trading and how does it work with our step-by-step guide for beginners.

Unlike investing in a physical asset, where investors only benefit when its value increases, CFD trading involves speculating the upswings and downswings in price. Key differences between CFD trading and investing in physical assets include ownership, leverage, and short trades. CFDs and investments can both be part of your financial plan. 

CFD Trading Essentials

  1. You can go long or short with CFDs - When trading CFDs, you’re predicting whether an asset’s price will rise or fall. If you think the asset’s price will go up, you’ll ‘buy’ and if you think the price will fall, you’ll ‘sell’. The outcome of your prediction will determine whether you make a profit or incur a loss.
     
  2. CFD trading is leveraged - Leverage in CFD trading enables you to get full market exposure for a small initial deposit, known as margin. It’s important to remember that potential profits and loss will be magnified, as it will be calculated on the full size of your position – not just the margin.
     
  3. CFDs behave similarly to their underlying market - CFD trading is designed to mimic trading each underlying market relatively closely. Some asset prices have a spread wrapped around it, while other CFD trades will incur a commission – it all depends on which market you're trading.

      

CFD Meaning  

The meaning of CFD is 'contract for difference', which is an agreement between an investor and a broker to exchange the difference between the opening and closing prices of a specified financial instrument, which can include forex, shares, cryptos, and commodities. 

What are CFDs? 

Contracts for difference are financial derivative products that allow traders to speculate on short-term price movements. There is no delivery of physical goods or securities with CFDs, you are just entering into an agreement that if the price goes in your favor, you make money, and if the price goes against you, you lose money. 

This is accomplished through a contract between client and broker and does not utilize any stock, forex, commodity, crypto, or futures exchange.  

The value of a CFD contract does not consider the asset's underlying value: only the price change between the trade entry and exit. 

CFD markets are offered by various online brokers like CAPEX.com, and therefore may differ from one broker to another. Typically they are trading instruments labeled with a similar name to the underlying.  

What are CFDs?

CFD Trading offers several major advantages that have increased the instruments' enormous popularity in the past decade. However, there are risks you might face for engaging in CFD trading. 

What is CFD trading and how does it work 

CFD trading is defined as ‘the buying and selling of CFDs’, with CFD meaning ‘contract for difference’ as explained above. A CFD is a derivative product because it enables you to speculate on financial markets such as shares, forex, indices, and commodities without having to take ownership of the underlying assets. 

Instead, when you trade a CFD, you are agreeing to exchange the difference in the price of an asset from the point at which the contract is opened to when it is closed.  

With most CFD markets, if you believe the underlying asset will rise, you buy the CFD. If you believe the underlying asset will decline in value, then you sell or short the CFD.  

A CFD involves two trades. The first trade creates the open position, which is later closed out through a reverse trade with the CFD provider at a different price. 

If the first trade is a buy or long position, the second trade (which closes the open position) is a sell. If the opening trade was a sell or short position, the closing trade is a buy. 

The net profit of the trader is the price difference between the opening trade and the closing-out trade (less any commission or interest). 

Develop your knowledge of CFD trading with us: Develop your knowledge of CFD trading with us: 

Long and Short  

CFD trading enables you to speculate on price movements in either direction. So while you can mimic a traditional trade that profits as a market rise in price, you can also open a CFD position that will profit as the underlying market decreases in price. This is referred to as selling or ‘going short’, as opposed to buying or ‘going long’. 

  • If you think Tesla shares are going to rise in price, for example, you could buy a share CFD on the company. 
  • If you think Tesla shares are going to fall in price, for example, you could sell a share CFD on the company.

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You’ll still exchange the difference in price between when your position is opened and when it is closed but will earn a profit if the shares drop in price and a loss if they increase in price. 

With both long and short trades, profits and losses will be realized once the position is closed. 

Leverage 

CFD trading is leveraged, which means you can gain exposure to a large position without having to commit the full cost at the outset. Say you wanted to open a position equivalent to 500 Amazon shares. With a standard trade, that would mean paying the full cost of the shares upfront. With a contract for difference, on the other hand, you might only have to put up a small percentage of the cost.  
  
While leverage enables you to spread your capital further, it is important to keep in mind that your profit or loss will still be calculated on the full size of your position. In our example, that would be the difference in the price of 500 Amazon shares from the point you opened the trade to the point you closed it. That means both profits and losses can be hugely magnified compared to your outlay, and that losses can exceed deposits. For this reason, it is important to pay attention to the leverage ratio and make sure that you are trading within your means. 

Margin  

Leveraged trading is sometimes referred to as ‘trading on margin’ because the funds required to open and maintain a position – the ‘margin’ – represent only a fraction of its total size. 

When trading CFDs, there are two types of margins. A deposit margin is required to open a position, while a maintenance margin may be required if your trade gets close to incurring losses that the deposit margin – and any additional funds in your account – will not cover. If this happens, you may get a margin call from your provider asking you to top up the funds in your account. If you don’t add sufficient funds, the position may be closed (stop out) and any losses incurred will be realized. 

Trading Platforms 

When you go on your trading platforms, you’ll find very little difference between buying and selling actual assets or CFDs. The look and feel of the platforms are easy to use. The choice to use leverage is the clue you are trading CFDs instead of other assets. 

With our CFD trading account you’ll have access to several trading platforms: 

  • Web-based platform 
  • Mobile trading app 
  • MetaTrader 5 

These can all be tailored to suit your trading style and preferences, with personalized alerts, interactive charts, pattern recognition, daily analyst rating, and risk management tools.

Benefits of CFDs 

Here we introduce some of the main advantages of CFD trading – including leverage, short selling, and hedging – and explain why these benefits are popular with traders. 

1. Global Market Access From One Platform 

Many CFD brokers offer products in all the world's major markets, allowing around-the-clock access. You can use contracts for difference to trade thousands of markets, including shares, indices, commodities, forex, cryptocurrencies, options, and more. And you don’t have to access multiple platforms to trade different markets. Everything is available under one login, wherever you need it – you can trade via your web browser, your phone, or your tablet. 

When you create a CFD trading account with CAPEX, you will be able to: 

When you create a CFD trading account with CAPEX, you will be able to: 

  • Trade over  2,000 international shares to speculate on their price rising or falling. 
  • Trade a host of global indices to go long or short on the performance of a large chunk of the economy with a single trade. 
  • Trade over 55 currency pairs, major, minor, and exotic with tight spreads 
  • Take a position on our range of  ETFs to get exposure to a basket of shares from an entire country, index, or sector. 
  • Trade a collection of E.U., U.S, and U.K. bonds 
  • Speculate on the energy prices, grains, and metals 
  • Access the hottest cryptocurrencies in the world.  

2. Higher Leverage 

CFDs provide higher leverage than traditional trading. Standard leverage in the CFD market is subject to regulation. It once was as low as a 1% maintenance margin (100:1 leverage), but is now limited in a range of 3% (30:1 leverage) in Europe and the UK and even less in the US and Japan.  

So, if Gold has a margin factor of 5%, then your margin would be 5% of the total exposure of your trade, whereby a position worth $2.000 (current Gold rate), may only require a deposit of $100. 

However, it’s important to remember that your total profit or loss is based on the full size of your position, not your deposit. 

Lower margin requirements mean less capital outlay for the trader and greater potential returns. However, increased leverage can also magnify a trader's exposure and losses. 

3. No Shorting Rules or Borrowing Stock 

Certain markets have rules that prohibit shorting, require the trader to borrow the instrument before selling short, or have different margin requirements for short and long positions. CFD instruments can be shorted at any time without borrowing costs because the trader doesn't own the underlying asset. 

Because a CFD allows you to trade on markets that are heading down as well as up, it is more flexible than other forms of trading. 

4. No Day Trading Requirements 

Certain markets require minimum amounts of capital to day trade or place limits on the number of day trades that can be made within certain accounts. The CFD market is not bound by these restrictions, and all account holders can day trade if they wish. Accounts can often be opened for as little as $100, although $1,000 to $5,000 is recommended deposit for proper risk and money management. 

5. Hedging  

If you have already invested in an existing portfolio of physical shares with another stockbroker and you think they may lose some of their value over the short term, you can hedge your physical shares using CFDs. By short-selling the same shares as CFDs, you can try and make a profit from the short-term downtrend to offset any loss from your existing portfolio. 

For example, say you hold $5000 worth of physical ABC Corp shares in your portfolio; you could hold a short position or short-sell the equivalent value of ABC Corp with CFDs. Then, if ABC Corp’s share price falls in the underlying market, the loss in value of your physical share portfolio could potentially be offset by the profit made on your short-selling CFD trade. You could then close out your CFD trade to secure your profit as the short-term downtrend comes to an end and the value of your physical shares starts to rise again. 

Using contracts for difference to hedge physical share portfolios is a popular technique for many investors, especially in volatile markets. 

Drawdowns of CFDs 

While CFDs offer an attractive alternative to traditional markets, they also present potential pitfalls. 

1. Traders Pay the Spread 

For one, having to pay the spread on entries and exits eliminates the potential to profit from small moves. The spread also decreases winning trades by a small amount compared to the underlying security and will increase losses by a small amount. So, while traditional markets expose the trader to fees, regulations, commissions, and higher capital requirements, CFDs trim traders' profits through spread costs. 

2. Weak Industry Regulation 

The CFD industry is not highly regulated. A CFD broker's credibility is based on reputation, longevity, and financial position rather than government standing or liquidity. There are excellent CFD brokers, but it's important to investigate a broker's background before opening an account. 

Recently governments have stepped in with increased regulations for CFDs and their trading platforms to better protect the traders. Financial Instruments Directive (MiFID) extended coverage of the European financial services to CFDs. Expect quality platforms to hold a European MiFID license (CySEC) and a British FCA license to give users the highest levels of compliance and risk management. 

3. Risks 

CFD trading is fast-moving and requires close monitoring. As a result, traders should be aware of the significant risks when trading CFDs. There are liquidity risks and margins you need to maintain; if you cannot cover reductions in values, your provider may close your position, and you'll have to meet the loss no matter what subsequently happens to the underlying asset. 

Leverage risks expose you to greater potential profits but also greater potential losses. While stop-loss limits are available from many CFD providers, they can't guarantee you won't suffer losses, especially if there's a market closure or a sharp price movement. Execution risks also may occur due to lags in trades.

What are the costs of CFD trading? 

Traditional investor fees vary. Some pay a fixed percentage of the assets in their portfolio, perhaps 2-3% each year. Some pay 5-6% on each trade. Even online discount brokers charge about $10 per trade. Savvy investors may be able to pay less when trading CFDs. 

Spread

Holding Cost 

Commission

When trading CFDs you must pay the spread, which is the difference between the buy and sell price. You enter a buy trade using the buy price quoted and exit using the sell price. The narrower the spread, the less the price needs to move in your favor.  At the end of each trading day, any positions open in your account may be subject to a charge called swap or 'holding cost'. The holding cost can be positive or negative depending on the direction of your position and the applicable holding rate. With most CFD providers you must also pay a separate commission charge when you trade share CFDs, a brokerage fee for using their services, applied when you buy and sell assets. Forex, commodities, and cryptos are usually commission-free. 

With CAPEX you can trade +2,100 markets with zero commission, including 0 Commission, unleveraged fractional CFDs on shares. 

      

The Anatomy of a CFD Trade 

When placing a CFD trade, there are a few things to keep in mind: 

1. Instruments 

When you trade CFDs with us, you can take a position on thousands of instruments. Our spreads start from as low as 1 pip on forex pairs including EUR/USD and GBP/USD. You can also trade the US 500 from 0.4 points and Gold from 0.44 points. See our range of markets here. There is also the option to trade CFDs over traditional share trading (fractional shares), which means that you do not have to take ownership of the physical share. 

Once you’ve opened and funded your account, it’s time to find your first trade. With CAPEX, you’ll be able to go long and short on over 2,100 markets, including: 

With so many markets to choose from, identifying your first trade can often seem daunting. That’s why we offer a range of integrated tools and features to help you decide on the deal that’s right for you: 

2. Buy and sell prices 

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

The price to buy will always be higher than the current underlying value and the price to sell will always be lower. The difference between the two prices is called the spread. All CFD trades with CAPEX are charged via the spread, including shares, which incur zero commission. 

3. Number of contracts 

When trading CFDs, you need to decide how many contracts you want to trade. Each market has its own minimum number of contracts: currencies pairs and most cryptos start from 0.01, most shares and indices start from one contract, while some commodities start from 10 and even 100. 

Keep in mind that as CFDs are leveraged products, you only ever need to put down a small deposit to gain exposure to the full value of the trade. This means your capital goes further but also means that you could lose more than your initial outlay. 

4. Stops and limits 

To help restrict your potential losses, you might choose to add a stop. Stops automatically close your position when the market moves against you by a specified amount. You can choose from a number of different types of stop orders, including: 

  • Basic Stop Loss: Closes you out as near as possible to the price level you choose. A basic stop may be affected by ‘gapping’ overnight or in times of high volatility 
  • Trailing Stop: Moves with your position when the market moves in your favor, but locks in as soon as the market starts to move against you 

Limit orders, meanwhile, do the opposite, closing your position when the market moves a specified distance in your favor. Limits are a great way to secure profits in volatile markets. 

5. Profit and Loss 

Once you’ve taken your position, your profit or loss will move in line with the underlying market price. You can monitor all your open positions on the trading app, and close them by clicking the ‘close’ button. You can also do this manually by placing the same trade you originally placed, but in the opposite direction (unless you force open the new position). So if you opened your position by buying, you could close by selling the same number of contracts at the sell price – and vice versa. 

For every point the price of the instrument moves in your favor, you gain multiples of the number of CFD units you have bought or sold. For every point the price moves against you, you will make a loss. 

CFD trading examples 

At first glance, CFD trades can seem more confusing than traditional trades – so here are some examples to guide you through the opening and closing positions. 

1. Buying Gold 

CFD trading examples - Buying Gold

Gold is trading at 1930.00 / 1930.40. 

Let’s assume the Japanese candlestick patterns indicates the price is more likely to fall. You decide to buy 10 CFD because you think the price of gold will go up. Gold has a leverage of 20:1, which means that you only have to deposit 5% of the total position value as position margin. Therefore, in this example your position margin will be $965.2 (5% x [10 x 1930.4]). 

Remember that if the price moves against you, it is possible to lose more than your initial position margin of $965.2. 

Outcome A: winning trade 

Your prediction was correct and the price rises over the next hour to 2015.40 / 2015.80. You decide to close your long trade by selling at $2015.40 (the current sell price). 

The price has moved 85$ (2015.40 – 1930.40) in your favor.  

Your profit is 10 x $85 = $850.  

Outcome B: losing trade 

Unfortunately, your prediction was wrong and the price of Gold drops over the next hour to 1865.30 / 1865.70. You feel the price is likely to continue dropping, so to limit the losses you decide to sell at 1865.30 (the current sell price) to close the trade. 

The price has moved $65.1 (1865.30 – 1930.40) against you. 

Your loss is 10 x ($-65.1) = –$651.  

2. Selling EUR/USD 

CFD trading examples - Selling EurUsd

 EUR/USD is trading at 1.10010 / 1.10020. 

Let's assume poor economic indicators data indicates that the euro is likely to fall against the US dollar in the coming days. You decide to sell 0.5 CFDs because you think the price of EUR/USD will go down. 

EUR/USD has a leverage of 30:1, which means that you only have to deposit 3.34% of the total position value as position margin. Therefore, in this example your position margin will be $1,833.5 (3.34% x [0.5 x 100.000 x 1.10010]). CAPEX WebTrader will automatically convert the position margin amount into your trading account currency at the prevailing conversion rate. 

Remember that if the price moves against you, it is possible to lose more than your initial position margin of $1,833.5.  

With CAPEX you benefit from a Negative Balance Protection policy, which means that you cannot lose more money than what is on your account. 

Outcome A: winning trade 

Your prediction was correct and EUR/USD drops over the next hour to 1.09500 / 1.09510. You decide to close your short trade by buying at 1.09950 (the current buy price). 

The price has moved 60 pips (1.10010 – 1.09510) in your favor. In FX, a pip is the 4th decimal. 

Your profit is ([0.5 x $100.000 x 1.10010] – [0.5 x $100.000 x 1.09510]) = $300.  

Outcome B: losing trade 

Unfortunately, your prediction was wrong and the price of EUR/USD rises over the next hour to 1.10450 / 1.10460. You feel the price is likely to continue rising, so to limit your losses you decide to buy at 1.10560 (the current buy price) to close the trade. 

The price has moved 45 pips (1.10460 – 1.10010) against you. 

Your loss is ([0.5 x $100.000 x 1.10010] – [0.5 x $100.000 x 1.10460]) = –$225.  

 

Before Opening a CFD Trading Account 

All online trading puts your money at risk. It also gives you the potential for profits. Before you open a CFD account, here are some things that increase your likelihood of success. 

Choose the right CFD broker  

Not all CFD brokers and trading platforms are the same. You want to ensure you are going with the highest quality. It is vital the provider is transparent. Some things to check for include: 

  • What legal rules are they governed by and agree to adhere to? 
  • How quick and liquid is the trading? 
  • What legal rules are they governed by and agree to adhere to? 
  • How much support and help can they give new or experienced traders? 
  • How easy is the site to use? Is it intuitive to navigate? 
  • How many assets are available to trade? Can you do currency, commodities, cryptocurrencies, indices, ETFs, stocks? 
  • Do you have features and tools for research and analysis? 

Educate Yourself 

Since many people use CFDs with leverage, it’s essential you understand how leverage works. It can add to your wealth, or it can destroy it. You need to know how to use it based on your portfolio size and risk level. 

You also need to develop a trading strategy. Most people who use CFDs are short-term traders or day traders, although CFDs can be used in buy-and-hold strategies if you use no leverage. In order to find more success in trading, you need to know how to use technical analysis, including technical trading indicators. This analysis will help you find entry and exit points. 

Most pros recommend practicing your strategy in virtual accounts. There you can experience real-time trading without risking actual capital. You can also backtest your strategy by going into the history of your asset to see how often the strategy would have given you wins… and how often it failed and produced losses. Learn more about scalping, day trading, and swing trading if you want to make frequent trades.   

CFDs are a great tool for a new type of investor. This is one who easily operates from their own home anywhere in the world, and harnesses the power of the crowds.  

CAPEX, the world’s leading one-stop-shop trading provider, sets a fine example of delivering the future of trading and investing today. Be sure to consider this award-winning platform. It helps to remember all trading involves risk. Only risk capital you are prepared to lose. 

CAPEX, the world’s leading one-stop-shop trading provider, sets a fine example of delivering the future of trading and investing today.  

  • CAPEX is a multi-regulated broker 
  • CAPEX is trusted by users worldwide 
  • Trade currencies, stocks, commodities, indices, and more in one portfolio 
  • Enjoy low spreads as low as 1 pip for EUR/USD and USD/JPY 
  • Protect your investments with advanced risk management features, such as real-time alerts and customizable stop loss 
  • Try CAPEX’s $50,000 demo account to experience CFD trading without risk 
  • CAPEX’s innovative QuantX allows you to automatically build your portfolio 
  • Dedicated customer support, Monday through Friday 

      

It helps to remember all trading involves risk. Only risk capital you are prepared to lose.

Free CFD trading courses and resources

Becoming a successful CFD trader takes skill, knowledge, and practice. We offer everything you need to get there, with a wealth of free trading courses and webinars at CAPEX Academy, as well as a free demo account, complete with $50,000 in virtual funds to help build your confidence in a risk-free environment.

We also offer trading strategy and news articles for all experience levels – so whether you’re a complete newcomer or a seasoned hand, we’ve got something for you. 

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Cristian Cochintu
Cristian Cochintu
financial_writer

Cristian Cochintu writes about trading and investing for CAPEX.com. Cristian has more than 15 years of brokerage, freelance, and in-house experience writing for financial institutions and coaching financial writers.