What Are CFDs & How To Trade With Them
CFDs are one of the most popular trading instruments worldwide, and this is your guide to everything you need to know. They offer the opportunity to access a wide range of markets without taking ownership of the underlying asset – and that's just one potential benefit.
We'll discuss the other advantages as well as the risks involved, the tax implications and how CFDs work. Read on for all the information you need about CFDs and how you can shape your strategy around them.
What to expect from our guide to CFDs
- What are CFDs?
- How do CFDs work?
- Can you trade CFDs without leverage?
- Do CFDs expire?
- What are the benefits of CFD trading?
- Are CFDs risky?
- Which markets can you trade via CFDs?
- What are some CFD trading strategies?
- Can you make money trading CFDs?
- Are CFDs worth it?
- Do you need to pay tax on CFDs?
- How do CFD brokers make money?
- How to trade CFDs and build your knowledge with Tradu
What are CFDs?
CFD stands for 'contract for difference'. A CFD is an agreement that a buyer will pay the seller the difference in an asset's value between the time the contract opens and when it closes.
CFDs are derivatives, which means you do not have to take ownership of the underlying asset. Instead, you are simply speculating on any movement in the price of the asset. You can trade in either direction, with the potential to make a profit even if the value falls, and not just in a bullish market.
Trading via CFDs is done with leverage, allowing you to open a full position while only depositing a relatively small proportion of the capital. That offers plenty of potential benefits – as well as posing possible risks – and we'll cover all of those later in this guide.
How do CFDs work?
If you think an asset's value is set to rise, you go long. If you think it's about to fall, you go short. If the market moves in the direction you predict – whether that's up or down – you stand to make a profit.
Trading on leverage means you only have to commit a percentage of the capital required for the full position. This is known as the margin. Let's break down a CFD trade with the use of a practical example in relation to the share price of a company:
- Company XYZ has a value of $ 200 per share.
- You predict that the share price is set to rise, so you choose to go long.
- You wish to trade the value of 100 shares, which equals a total position of $20,000.
- You're trading on leverage, and your broker requires you to put up 20% as your initial margin to open the contract. That means committing $4,000.
- As you predicted, the share value of Company XYZ rises – to $250.
- You close the contract having made a profit of $5,000, before any commission fees or charges are deducted.
In the above example, the trade works out in your favour. But let's look at how it works if the market moves against you.
- Instead of rising to $250, the share value of Company XYZ falls to $150.
- You cut your losses and close the contract.
- Because you're trading on leverage, you are exposed to the full $20,000 position, not just your $4,000 margin.
- Including the loss you've made on the trade, your exposure on the position stands at $25,000.
Can you trade CFDs without leverage?
No, trading via CFDs will always involve leverage. If you don't want to trade in this way then you might want to consider investing directly. This will mean you take ownership of the underlying asset and will only be able to make a profit if its value increases. It also means you will have to commit 100% of the capital to open a position.
Do CFDs expire?
It may depend on the markets you are trading in, but with CFDs you can usually hold your position open for as long as you like. The common exceptions are if you are trading futures and options, which have an expiry date. Please note that you cannot trade futures or options with Tradu and this article is for informative purposes only.
What are the benefits of CFD trading?
CFD trading is popular with millions around the world, and there are plenty of potential advantages that make it an attractive proposition:
- Trading with leverage means you can open a position while only putting up a percentage of the capital. This could be as little as 5% depending on the market and your broker.
- Because CFDs are a derivative, you don't have to take ownership of the underlying asset when you trade.
- Depending on where you live, you can benefit from certain tax breaks when trading CFDs. In the UK, for example, there is no stamp duty to pay on any profits you make. You may have to pay capital gains tax, but this can be offset against your losses which enables you to hedge your positions.
- Through CFDs, you can access a wide variety of markets – including the likes of forex, shares, indices and commodities.
- CFDs enable you to trade in either direction. So, you could stand to make a profit in bearish or bullish markets, as long as your prediction proves correct.
Are CFDs risky?
Any form of trading carries a degree of risk, and CFDs are no different. When you open an account, there a various factors that you need to take into consideration. For example:
- CFDs are a leveraged product, which as discussed above, offers the opportunity to magnify your profits. But trading on margin means you are still exposed for the full position. So, if the market moves against you, your losses will be magnified.
- CFDs are an over-the-counter product, meaning that they are not listed on a major exchange and are instead traded via a broker-dealer network. In the last couple of years, the industry regulation has become more stringent and regulators have placed restrictions on the sale of CFDs to retail clients in some jurisdictions.
- There are costs for you to take into account when trading CFDs. For example, if you want to maintain your position overnight, you may incur an additional charge from your broker. There may also be commission fees to pay, depending on the assets you are trading. All of these can eat into any profits you make.
Which markets can you trade via CFDs?
Opening a CFD trading account offers access to a wide range of assets, meaning you can diversify your portfolio as you see fit. CFD trading is available for markets including:
- Forex
- Shares
- Indices
- Commodities
Commission fees and margin requirements may differ depending on the market you choose, so it's important to do your research and understand those factors before opening any positions.
What are some CFD trading strategies?
The strategy – or strategies – you choose will depend on a number of things, such as your level of knowledge and expertise, as well as your trading objectives. Common approaches include:
- Day trading: Opening and closing positions within the same day. This will avoid incurring any overnight charges.
- Trend trading: Analysing historic price movements with a view to predicting future performance and executing trades accordingly.
- Swing trading: Using analysis to predict when a trend might be about to end and price movements are set to 'swing' in the opposite direction.
- Range trading: Identifying where an asset's value tends to remain within certain upper and lower limits and trading within that range.
- Breakout trading: Identifying where an asset's value could be set to 'break out' of those resistance and support levels.
Find out more in our guide to trading strategies.
Can you make money trading CFDs?
Trading CFDs offers the potential to make profits if your predictions prove correct and the market moves in your favour. And because trades are executed using leverage, you can open a full position while only putting up a proportion of the required capital. The margin requirements will vary between asset classes.
But bear in mind that you will still be exposed for the full position. Using the example quoted earlier in this guide, you would be exposed for the full amount of $20,000, not just the $4,000 you committed as a deposit.
Are CFDs worth it?
The answer to this will be different for each individual trader. When using CFDs, you need to make sure you have a full and detailed understanding of how they work, how profits and losses are calculated, and the potential risks that are involved.
Once you have established that level of insight, you will be able to measure the profit-making potential against your appetite for risk. Identifying an acceptable risk-reward ratio is a personal choice and, of course, if your trade is profitable, you will consider CFDs to be a worthwhile instrument in that particular instance. But the nature of trading means there are no guarantees when it comes to opening any position in any market.
Do you need to pay tax on CFDs?
That will depend on your location. For example, CFD traders in the UK do not have to pay any stamp duty on the profits they make, but there is capital gains tax to pay. The various rules and regulations will vary in different countries, so it's important that you understand these and how they will affect you before you open an account.
How do CFD brokers make money?
Most CFD providers and brokers will set a spread, meaning you'll buy at slightly above market price and sell at slightly below it. This is factored into the cost of your trade. Your broker may also charge a commission for opening and closing the position and this fee will be deducted from any profits you make – or added to any losses you incur.
How to trade CFDs and build your knowledge with Tradu
You can trade CFDs with Tradu via our proprietary platform . Once you've opened your account and conducted your analysis, the next step is to select the asset you want to trade and decide if you want to go long or short.
Decide the size of position you wish to open and put up your capital based on the margin requirements for that market. You may wish to set up a stop-loss order to limit your risk, and if your prediction proves correct you can close your position having earned a profit.
You can find out more in our guide on how to trade CFDs and if you're ready to get started you can open an account with Tradu today.
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