What is CFD Trading and How Does It Work?

 Justin Paolini

This is a guide to “CFD trading for beginners”. In this article, you will learn which financial instruments are available to trade in the CFD market. We will show you why you should consider CFDs as part of your trading strategy by examining their advantages. When you are ready to start trading CFDs, check out our list of the best CFD brokers.

Contracts for Difference (CFDs) have been around since the early 2000s, and their use by hedge funds and individual traders has grown exponentially. Originally created for institutional players that wanted a flexible, leveraged product that would allow them to hedge their portfolios while avoiding British stamp duty, CFDs in Forex and in other non-Forex assets quickly gained traction in the retail market as well. But what are CFDs exactly? Why do brokers seem to be continuously enhancing their product offering with more CFDs? Why and when should a trader prefer to trade CFDs rather than trade in stocks, futures or rolling spot Forex? Welcome to our guide to CFD trading for beginners.

What is a Contract for Difference?

Starting right from the basics, CFD stands for “Contract for Difference”. Understanding CFDs is quite simple:

  • A CFD is a contract which you can buy (or sell) at one price and sell (or buy back) at another.

  • The price movements of a CFD mimic whatever underlying security they are based on (Indices, Shares, Commodities, Forex, etc).

  • Your profit or loss will depend on the difference of the buy and sell price.

In other words, a CFD gives you the right to own the price difference between the opening and closing price of your trade, which is why it is a “Contract for Difference” after all. However, you do not actually own the underlying security, which is the difference between trading a CFD and investing.

For example, here is a chart of the “real” Dow Jones Futures (via TradingView) from February 2021 to March 13th, 2021.

Dow Jones Futures February-March 2021

And here is the Dow Jones CFD chart, as offered by a regulated broker.

Dow Jones CFD February/March 2021

Clearly, the CFD chart is a faithful replica of the real Dow Jones Futures.

Pros and Cons of CFDs

Pros

  • A vast universe of instruments to trade including shares, indices, commodities, and currency pairs.

  • The high degree of leverage available means you have small margin requirements, making CFD trading highly efficient.

  • You can short CFDs without having to go through the intricacies of traditional short selling.

  • CFDs are exempt from stamp duty (in the U.K.).

  • You can deduct your losses from profits for tax purposes (in the U.K.).

Cons

  • You can lose more than your initial deposit.

  • When used improperly, leverage can magnify losses so be sure to use solid money and trade management strategies to insulate your account from large losses.

  • Trading CFDs profitably requires skill and experience. Get to know the intricacies of the instruments you are trading and consider trading with a demo account for some time before risking any real money.

  • Any positions left open overnight are subject to funding fees.

  • CFD profits are subject to capital gains tax (in the U.K.).

Types of CFDs

CFDs are available on a huge range of assets including global indices, stocks, currencies, commodities. Therefore, by trading CFDs you can diversify your positions which means that your range of opportunities increases exponentially compared to a trader that only focuses on one asset class such as Forex, for example.

Let us examine the main differences between CFDs and other financial instruments.

CFDs vs. Forex: like Forex, CFDs are OTC (over the counter) products (so there is no central exchange) and if you take a position with a CFD you do not physically own the underlying asset. Whether you buy EUR/USD or the S&P 500 Index CFD, you are just taking an educated bet on the possible short-term price movement. However, whereas all currency prices are driven by geopolitical events (Brexit, Coronavirus), economic data (inflation, GDP, employment) and interest rates (yields), CFDs can differ. The price oscillations of a CFD depend on the underlying instrument. A CFD based on WTI Crude Oil will move depending on the demand/supply characteristics of the oil market; a CFD on the S&P 500 Index will be mostly dependant on global growth prospects; a CFD on a single stock like Tesla will be dependant on specific news relative to renewable energy, tweets by Elon Musk, earnings prospects, growth prospects, and the company’s regulatory environment.

CFDs vs. Futures: CFDs and futures are both derivative products that are based on an underlying asset. You can go long or short in both CFDs and futures. The main differences between CFDs and futures contracts are the contract size and margin requirements. CFDs allow much more flexibility and can be traded with smaller account sizes because of the granularity of their pricing structure and leverage. Yet CFDs are also simpler: while futures have expiry dates, CFDs do not. Also, CFDs do not require physical delivery. Imagine trading WTI Crude Oil futures and forgetting to roll the position over: you would be accountable to take physical delivery of the number of barrels you were trading. This cannot happen when trading CFDs, because you do not physically own any of the underlying asset.

CFDs vs. Commodities: “fewer headaches” is how we can describe CFD trading as opposed to traditional commodity trading. CFD traders need not worry about physical delivery, contract expiry, or lot sizes. As such, when trading CFDs on coffee, crude oil, wheat, copper etc., you only need to focus on your pre-trade analysis, trade execution and trade management. Your trading is much more efficient and much less complex.

CFDs vs. Stocks: whether to trade physical shares or CFDs boils down to capital availability and objectives. For example, when trading stocks you pay the full value of your stocks upfront, whereas the leverage available on CFDs make them a more efficient instrument to use. However, on CFDs your losses can exceed your initial deposit, whereas in stocks you can only lose the amount you invested. However, stocks have limitations on short selling, whereas CFDs allow you to trade either long or short without any restrictions. Stock trading is limited to the open hours of the relevant stock exchange, while CFDs can be traded around the clock subject to your broker’s market hours. Ultimately, stock trading is perhaps better suited for longer-term objectives because there is no time-based fee incurred to keep trades open, whereas there is a cost to holding CFDs overnight (as described previously). Therefore, CFDs are more directed towards intraday and swing trading, whereas stocks are more suited for long-term investing.

CFDs vs ETFs: this is a more interesting comparison because CFDs and ETFs are both speculations on the movement of the underlying instrument (in neither case does the trade own the underlying instrument). However, ETFs are perhaps more useful for longer term strategies (like stocks) whereas CFDs are more useful for short-term strategies. ETFs are quoted on public stock exchanges and can represent entire sectors, industries, commodity baskets, and as such can offer internal diversification benefits while maintaining low costs. The closest match to CFDs are index ETFs (like Dax or S&P 500 ETFs). But even here there are differences: with ETFs you must pay the full price of your underlying asset, whereas the leverage available on CFDs make them more efficient to use. With ETFs you can never lose more than your initial investment, while with CFDs you can. ETFs are not subject to rollover fees, whereas CFDs are. As such, ETFs are best used for longer-term strategies like dollar-cost averaging, asset allocation, and risk-parity; CFDs are best used for short-term directional trading. Happily, several Forex brokers now offer CFDs on more popular ETFs, meaning that traders can perform ETF CFD trading and benefit from exposure to ETFs in CFD format.

CFDs vs Options: options are perhaps a more efficient way to trade stocks due to the fact they have embedded leverage (1 option typically allows you to control 100 shares of a company) but the benefit might end there. Like CFDs, options are derivative instruments that move based on the direction, volatility, and liquidity of the underlying security, as well as the time to expiry. Options have an expiry date and so have something in common with commodity futures. But options are certainly more complex to understand due to the multiple variables that impact their price. Also, options are almost entirely directed at stocks whereas brokers have created CFDs on many different asset classes.

What is CFD Trading?

CFDs trading is a form of leveraged trading, where the broker allows you to control a large position with a relatively small amount of money (this small amount of money is margin). The leverage can of course work for you or against you because your profit and loss is dependent on the notional value of the position you control, so the best illustration requires working through an example to understand what this means in practical terms.

An Example of a CFD Trade

Let us look at an example of a transaction.

Most brokers offer “micro-size” positions in CFDs, so even clients with very small accounts can take a CFD position based on their views.

Example of a CFD Trade

As you can see, in this (realistic) example, we have gained more than the margin required to make the trade. We could have easily lost more than the margin requested for the position. In this sense, CFDs are high leverage products. The financing cost seems very low at this point, but we are in a moment of low interest rates. In these moments, Issuers gain marginally less on their financing haircut BUT they get to charge clients on both the long AND the short positions.

Now for another example, with a 5-day holding period. Observe how much financing can impact the end profit, even in a low-rate environment.

Example of a CFD Trade 2

What are we trying to illustrate? Simply that CFDs can get expensive, especially if you are on the wrong side of the market. But without even considering the uncertain outcome of any given bet, let us explore the costs, in terms of volatility (measured by the average true range indicator) of trading a CFD on the Dax Index.

The Dax usually moves with relatively high volatility. Hence, there is much opportunity here for profit or loss. Now, we have been in an extended low-rate environment, so for simplicity we can considering the same (extremely low) financing cost seen in the example above, or $0.90 per day. We have taken the average true range of the Dax in low volatility and higher volatility environments.

DAX CFD Financing Costs Example

When interest rates finally start to rise, the financing costs will rise in lockstep. So, CFDs are short term trading vehicles, because over the long term, the financing cost will significantly impact your P/L.

This is the main difference between CFD trading and investing. It is inefficient to use CFDs for long-term positions. Instead, CFDs are best used for intraday and short-term positions.

How to Trade CFDs

Most retail traders are familiar with Forex trading strategies. As noted above, currency prices are driven by geopolitical events (Brexit, Coronavirus), economic data (inflation, GDP, employment) and interest rates (yields). The price oscillations of a CFD depend on the underlying instrument. So, it is worth looking at the fundamental influences that impact different kinds of CFDs:

  • Index CFDs

  • Crude Oil CFD

  • Gold CFD

  • Industrial Metal CFDs

How to Trade Stock Index CFDs: Growth is Key

Since they represent a group of stocks, all index CFDs follow the same dynamics and since the world is now more interconnected than ever before, most stock index CFDs are strongly correlated as the chart below shows.

Major stock indices 2020-2021

Major Stock Indices 2020-2021

Mathematically, we can divide all stock price changes into just two categories:

1. A stock's price can change because its multiple(s) change. This means that stock traders change their view of what a stock is worth without any underlying change in the stocks achieved revenues or earnings. For example, the (trailing) P/E ratio or multiple changes, or the price to book value ratio changes. Generally, this means that the outlook for future earnings has become more positive or more negative or the required rate of return on the stock has changed. Multiple changes are responsible for almost all minute-to minute, movement in stock prices.

2. A stock's fundamentals change due to the release of new financial data. For example, the stock's book value, trailing 12 months revenue or trailing 12 month's earnings changes when it releases financial performance for the latest quarter. Fundamental growth is responsible for most of the long-term change in a stock's price over a period of years.

Now, since Index CFDs are a weighted average of stock prices, we know what makes them tick: growth! Earnings are the cornerstone of stock analysis and Indices also have their own earnings figures. When the economy is doing well, companies are producing and selling their goods/services and thus the forecast for future earnings is good.

Correlation Corporate Profits and the Dow Jones Index

Correlation Corporate Profits and the Dow Jones Index

Vice-versa: when things start to look gloomy, when the consumer is not purchasing or when there is some perception of emerging risk, the outlook for the future is not so certain or positive. Having a good grip on the fundamentals of the US economy (for the Dow), the German economy (for the Dax), the Canadian economy (for the TSX) and so on, is the only thing you – as a trader – need to understand the oscillations in price of an Index CFD. If everything is based on growth, then the resolving question is: how is the economy doing, and how are the emerging data prints fitting into the current context?

How to Trade Crude Oil CFDs

Here are the main drivers to pay attention to, to understand how and why the price of Crude Oil moves. Remember, prices move because market participants shift their expectations for the underlying asset and these expectations are based on emerging fundamentals, not charts alone.

  1. Risk Appetite and Supply Side Shocks. As is the case for most growth-sensitive commodities, Crude Oil is influenced by risk appetite, over and above the prevailing balance of supply and demand. When general supply/demand dynamics are driving price, the correlation between EIA/API Inventories and Crude is evident. When risk is the driver, the correlation between Crude, the VIX index and the DOW becomes more evident.

Vix Index (Blue) vs. Crude (Green & Red) – Weekly View

Vix Index (Blue) vs. Crude (Green & Red) – Weekly View

Dow (Blue) vs. Crude (Red & Green) – Weekly View

Dow (Blue) vs. Crude (Red & Green) – Weekly View

  1. The EIA Crude Oil Stocks Change (which is issued every Wednesday) really is the most important data print. It is a weekly measure of the change in the number of barrels in stock of crude oil and its derivates and tends to generate large price volatility as oil prices impact worldwide economies. In Forex, these dynamics can have an impact on commodity related currencies such as the Canadian dollar.

Inventories Week to Week %-change (blue, lhs) vs. Crude %-change (orange, rhs)

Inventories Week to Week %-change (blue, lhs) vs. Crude %-change (orange, rhs)

  1. The API Weekly Crude Oil Stock (issued on Tuesday evenings) have become a little more popular recently but are generally less followed than official EIA data. The American Petroleum Institute attempts to anticipate official EIA data and as such has validity.

How to Trade Gold and Metal CFDs

Gold really is the king of all commodities. Understand Gold, and you can understand all other precious metals. Gold tends to have an impact on other precious metals like Silver and Platinum, dictating their price, and more so with Silver because Platinum is more oriented towards industrial use.

There are 4 main reasons that make Gold the most important precious metal in the world:

  • Central Banks hold large amounts of Gold as part of their official reserves and buy & sell large amounts of the metal based on their future expectations for the economy.

  • In times of risk aversion, traders and investors shift capital away from risky assets and search for security in Gold as highlighted by the chart below.

Gold vs. Dow Jones Index 2014-2021

Gold vs Dow Jones Index 2014-2021

 

  • USD trends affect Gold since the metal is primarily priced in USD per ounce, so naturally lower USD prices tend to increase the relative value of Gold (and vice versa) as highlighted by the chart below.

Gold vs. US Dollar Index 2014-2021

Gold vs US Dollar Index 2014-2021

  • Inflation trends also affect the demand for Gold, since the precious metal is seen as a hedge against inflation.

Silver CFDs

It might be interesting to know that Silver has a huge array of industrial uses, since it is used as electrical components in computers and household appliances such as washing machines. It also has less conventional uses, such as in photograph development and in odour control in shoes and clothes. It is also more commonly being used in trace amounts in bandages and is still used in X-rays.

But for day-to-day trading, one chart says it all:

Gold vs. Silver 2008-2021

Gold vs Silver 2008-2021

Silver tracks Gold. The price dynamics are very much the same, albeit with different volatility characteristics. Hence, for trading objectives, Gold remains more appealing given the higher volatility.

Platinum and Palladium

Palladium has a wide variety of uses, and thus appears several consumer and business market. Despite being a precious metal, Palladium tends to track the stock market. Its industrial uses tend to overshadow its status as a rare metal. So, one of the best ways to use Palladium charts is to spread it against Gold. This shows how well the industrial (real) economy is doing and the Palladium/Gold spread will turn bearish quickly when the economy starts to slow down. On the one hand you have diminished demand for consumer products which impacts the demand for Palladium. On the other hand, you have a tendential flight to safety.

Palladium/Gold spread vs. Dow Jones IndexPalladium/Gold spread vs. Dow Jones Index

Platinum is also a rare metal and is used for jewellery. However, just like Palladium, it has industrial uses that overshadow its status as a rare metal. Platinum is used in the automotive industry, and in the medicinal industry. Again, Platinum trades like Palladium but it tends to be more sensitive to economic shocks. Platinum’s spread against Gold is a much better indicator of what market participants think about the future prospect for the economy.

Copper is yet another industrial metal with demand/supply characteristics that are much more like Palladium and Platinum than Gold or Silver. Being a good heat conductor, it has a wide range of uses in the construction, electronics, and transportation industries. So economic growth prospects are usually the strongest driver of copper prices, alongside USD dynamics. Also, the demand for copper is highly correlated with the economic growth prospects of China and India.

Copper (Orange) vs. Dow Jones Index

 Copper (Orange) vs. Dow Jones Index

How is a CFD Quoted?

Many traders are confused by the difference between the actual Futures price and the CFD quote. To make matters more confusing, each broker basically has a different quote for the same product. The reason why CFDs “track” the underlying instrument but have a different quote lies in the calculations made to “create” the CFD in the first place:

CFD Creation Formula

 

For the finance geeks that really want to understand a CFD's pricing structure, let us get technical for a moment.

If the CFD Price = PT and the price of the Underlying = UT, when a trader and his broker get into a CFD trade at time t, the condition must be that:

  • For each moment in time prior to the close of the trade (T) the cash flows between parties are as follows: the buyer of the CFD must pay the seller interest of r*Ut-1 (contract rate of interest per day, applied at rollover time) and the seller must pay the buyer any dividends Dt

  • At time T (the close of the position) there is a cash flow of PT - Pt = UT - Pt

So, the CFD pricing mechanism that keeps the CFD price locked to the underlying price, and that also satisfies futures pricing equations, is:

PT-1 = FT-1 – (UT-1*(er-1)) + DT = UT-1

This is the financing cost (contract interest) justified by the fact that the CFD issuer (i.e. the broker) should have a physical position in the underlying, for which it has set aside margin, and is not creating CFDs for free.

The explicit financing calculation is usually expressed as follows:

Financing = (amt*close*rate)/365

Where:

amt = Trade Size

close = daily closing price of the CFD contract

rate = relevant 3Month LIBOR rate (usually), to which the CFD issuers usually add (for long positions) or deduct (for short positions) a certain amount. For example, if your broker adds 3% to longs and deducts 3% for shorts, so effectively their haircut is 6% (because they make you pay 3% on the longs and they give you 3% less on the shorts).

We should try to understand a little more what the pricing formula means:

  • Long 1 CFD = PT-1 = FT-1 (UT-1*(er-1)) + DT so the client benefits from (positive) future price variation and the dividends and pays Libor 3M+3% (in our example).

  • Short 1 CFD = - PT-1 = - FT-1 + (UT-1*(er-1)) DT so the client benefits from (negative) future price variation and Libor 3M-3% (in our example) and pays the dividends.

Why is it beneficial for a CFD issuer (a CFD broker) to offer as many CFDs as they possibly can?

CFD Financing Terms

The above example is a case of the CFD issuer acting as a DMA issuer (not a Market Maker) and hedging its CFD exposure in the market with the underlying future. So, the issuer is acting in the most transparent way possible, eliminating any potential conflicts of interest. It seems all the terms cancel themselves out (without transaction costs, obviously) but brokers do not offer CFDs for free. So where is the benefit?

The benefit is in the financing term! In our example, the market rate at which the issuer can transact is Libor3M, while it charges the client 3% on the long side and deducts 3% from the interest that the client would otherwise benefit from on the short side. The total haircut that the issuer (in our example) is receiving is 6%. In fact, it is likely that the issuer benefits from at least 2*Libor applied to the client. Yet that the issuer also benefits from the spread it applies which is much wider in percentage terms than the spread applied to the underlying stock or future.

In plain English, here is the simplified explanation:

  • Financing costs are where your broker will make money, above and beyond the spread you pay to make the transaction.

  • Financing costs are high and generally deplete the profit obtained on trades that last more than a couple of weeks.

  • It follows that CFD trading is directed at short term forays into the market and is not appropriate as a vehicle for position trading.

  • CFDs will always track the underlying market, considering how they are built and quoted.

Final Thoughts

CFDs are a flexible, leveraged, short-term trading instrument. The benefit of CFDs is that traders can trade a vast array of different instruments via CFDs, since brokers nowadays create CFDs on practically all asset classes (stocks, forex, commodities, indices, metals, bonds). However, traders need to have a firm grasp of risk management and money management principles to properly trade CFDs while avoiding margin calls.

FAQs

Is CFD Trading Profitable?

CFDs are simply an instrument that allows you to take a stance (bullish or bearish) on a given financial asset. As such, to be profitable you must possess solid trading skills. Also, the high degree of leverage available with CFDs means you need to have a firm grasp of money management and trade management practices to be profitable.

Some common mistakes you want to avoid:

Not having a solid trading system when trading CFDs.

Holding onto losing positions, hoping they will go up.

Getting into a position based on somebody else’s idea.

Increasing your position size after a loss, hoping to make back previous loses.

How Do I Start Trading CFDs?

When you start CFD trading as a beginner, you should first consider opening a CFD demo account with a regulated broker where you can practise trading in a risk-free environment. Once you have become familiar with CFDs, you can:

  • open a live trading account with a regulated broker,

  • choose the instrument you want to trade,

  • enter a trade size,

  • execute the order,

  • monitor/manage your trade,

  • close the position.

Why are CFDs Illegal?

CFDs are not currently allowed in the USA due to restrictions imposed by the S.E.C. due to the fact they are OCT (over the counter) financial instruments and are heavily regulated.

Is CFD Trading Safe?

CFDs are a leveraged financial product, and as such should be treated similarly to other leveraged products. CFDs have been traditionally used by sophisticated traders to take advantage of opportunistic, short-term positions in the markets. Retail traders are lured towards CFDs because of the capacity to make large profits from small moves on the underlying instrument (be it an index, a stock, a currency pair, a commodity, etc). This is due to leverage: the fact that brokers require for example 10% margin (so you only need $100 to control a notional value of $1000).

To sum up, there is nothing inherently unsafe about CFDs.

 Justin Paolini

Justin Paolini helps traders succeed through 1-on-1 coaching at BuildingaTrader.com. He is also Head of Trader Development at FCI Markets UK. Justin has over 15 years of experience trading Forex of which 3 were spent as a Sales Trader and as a Broker. Previously, he was an analyst at 3CAnalysis.com, producing institutional grade directional calls. His market commentary has been published on FXRenew.com, Yahoo! Finanza, Trend Online, FX Street, OrderFlowtrading.com, and ForexTell.com. For the past 8 years, he has dedicated himself to helping others succeed, and has been a guest lecturer at the University of Ancona on Trading and Market Dynamics.

Justin holds a B.A. in Economics & Finance from UNIVPM, Ancona, and a Masters in Finance, Banking & Insurance.

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