Beginner's Guide to Trading CFDs

Joe Damien

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.

What Are CFDs?

What are CFD in Forex? “CFD” is an acronym for “Contracts for Difference”. CFDs give investors the opportunity to trade based on the price movement of a particular financial asset (whether Forex, stocks, commodities, etc.) without actually having to own it, allowing for leveraged “bets” if desired.

When trading CFDs in Forex, investors speculate on whether the price of a currency pair will move up or down. When the price of a pair is seen to be going up, the speculators (traders in the market) will execute long positions. Alternatively, if the price looks like heading down, they open a short position. The profit and loss will be the difference between the price they bought at and the price they sold at.

A quick example to make things clear:

Say you want to trade EUR/USD using a CFD contract.

You have the following bid/ask spread: 1.1900/1.1905.

After conducting your analysis, you believe that it is likely that the price of the EUR/USD will move upward over the coming days to 1.1910/1.1915.

So, you buy 1 contract of CFD at the ask price of 1.1905. It gains value, and you finally sell it at the bid price of 1.1910.

Note that each CFD contract worth one lot, has a value of 100 000 units of base currency (one standard lot).

Profit = 100 000 * (1.1910 – 1.1905) = $50.

In the case that your analysis proved wrong and the price moved in the opposite direction, your loss would be – $50.

Traders and brokers execute their CFDs trades using the Over the Counter (OTC) method. However, this type of trading has come under scrutiny in the U.S. As a result, American citizens are not allowed to participate in this type of market since it was banned by the Security Exchange Commission (SEC). Later in this article, we will explain to you what are CFDs in Forex and how you can benefit from this type of CFDs in your trading.

Why You Should Trade CFDs

Many reasons might lead a trader to consider CFDs as part of his or her trading portfolio. In this section, we will give you the main advantages in trading CFDs. We will go through six different reasons and explain them in detail.

High Leverage

Trading using leverage involves depositing a relatively small amount with a broker who lends you more on the strength of that to trade bigger in the market. Usually, CFD brokers ask between 2% to 3% of position size as required margin on CFD trading. What does this mean?

Imagine you decided to open a buy position of 1 CFD contract (1 standard lot) of EUR/USD, which is equivalent to 100,000 units of its base currency (EUR).

Since the required margin is as low as 2% you only just 2000 EUR to be able to trade 100 000 EUR. Hence, this is a big advantage of trading using CFDs. You do not need a huge amount of money to participate in this market.

Ability to Sell Short

There are certain financial instruments that you cannot short sell without owning or borrowing the asset first. Since trading CFDs does not involve any exchange of the asset, you can short sell with no restrictions and with no extra cost of borrowing.

Ability to Trade Several Asset Classes

In the global CFD market, traders can choose from a range of over 17,000 financial assets to trade with. Traders have the option to trade commodities, indices, forex, stocks and even cryptocurrencies. So, the CFD trader has access to a very wide range of options for portfolio diversification.

No Expiry Date

Unlike the futures contracts or options, CFDs do not expire.  On the contrary, you can leave a CFD position open for as long as you want (subject to individual limits a few brokers might impose), as per your trading strategy. Like other types of assets, in the CFD market you can use stop losses and profit targets to automatically ensure trade exits to avoid to the need for continuous monitoring of the trade.

Ability to Hedge

When trading CFDs, it is usually possible to open a sell position even if you already have an open buy position in the same financial asset. This allows you to use CFDs as part of your hedging technique. This is restricted in some markets where brokers and regulations ban traders to execute two opposite trades on the same underlying asset. However, there are many brokers allowing hedging.

Low or No Minimums

The CFD market does not require a large initial deposit. Typically, you can open a CFD trading account with as little as $100 of capital. Every CFD broker has its own minimum requirement that you should check before opening a real account.

CFD Markets

In this section, we are going to discuss which kinds of financial assets you can trade using CFDs.

Forex

There are several ways to trade forex. You can choose to trade it using spot, futures, or CFDs. In spot, the trader speculates by exchanging one currency for another at the current market price. However, in futures, the seller and buyer exchange the currencies at a pre-determined price and time. When it comes to Forex ETF CFDs, traders have the option to trade on margin to gain a much bigger exposure to the market. There is no need to deposit the full amount of a trade, just the required margin. However, a trader should be aware of the risk when trading with high leverage as this could lead to big losses. You might ask yourself, what is the difference between CFDs on Forex and Spot Forex? There are no huge differences, but you should know that Forex CFDs are not found on common exchanges, as we have said in the beginning of this article, they are traded over the counter. When trading CFDs on Forex, in fact you are trading against your broker. So, when you open any position, your broker takes the opposite side of the trade. Essentially, when you win, your broker loses, and vice versa. This might tempt your broker to manipulate their piece feed when they have a lot of highly leveraged clients with similar stop loss levels.

Commodities

commodity trading

Useful or valuable materials such as gold, silver, crude oil, iron ore, sugar, and many others are considered to be commodities in the financial markets. They are often the raw materials of the global economy. The price of commodities is highly affected by supply and demand, as well as by macroeconomic factors. Traders can buy and sell these assets using CFDs, which provide an ability to speculate on the price of a commodity without physically owning it. For example, say you decided to buy ten contracts of a crude oil CFD, you will not receive a physical barrel of oil which you will need to store somewhere. You just make profit or loss based on the price movement of the crude oil market. The main advantage of trading using CFDs on commodities is that the required margin is lower than that in trading commodities futures. This gives you as a trader the chance to deposit less and trade bigger in the market by using CFDs. When you buy commodity futures you pay a daily interest, but when you sell commodity futures short you receive daily interest. However, holding a long position in CFDs is usually less costly than taking a long position in commodities futures.

ETFs

An “ETF” is an “Exchange Traded Fund”. This is simply a fund that can be bought and sold publicly in share units, like a mutual fund, but which is based on an asset or baskets of assets, for the sake of convenience. It is probably simplest to think of it as a type of mutual fund. For example, if you want to invest in Gold Mining Shares, you could buy a share in a Gold Mining ETF that tracks the market capitalization weightings of all shares in Gold Mining companies quoted on a particular exchange. It is a way to be exposed to an asset or some kind of index representing a type of asset without all the cost and trouble of actually having to buy it all directly.

These four definitions – Spot Forex, Futures, CFDs and ETFs – are not all mutually exclusive. For example, a gold trading broker could offer a CFD instrument based upon a Gold Futures ETF. The only exclusivity here is between Spot and Futures.

Stock Indices

Stock trading

A stock index measures the combined performance of several stocks traded on a particular exchange. Indices have theoretical values but are monetized in funds so can be traded or made the object of investment. Two very widely traded indices globally are the NASDAQ 100 technology index and the broad index of the largest publicly listed companies in the U.S.A., the S&P 500 index.

Index CFDs are attractive to traders wishing to speculate on the performance of an entire economy or maybe a particular index or sector within that economy, or even across several economies as there are some multinational indices.

Final Thoughts

In this guide to CFD trading for beginners, we have summarized why and how you can profit from trading CFDs in financial markets. We have also highlighted the main advantages in using this asset class. You may now be considering including CFDs within your trading plan. However, as we briefly mentioned earlier, there are always risks in trading on margin we need to remind you of these. CFD trading may allow you to make a lot of money but at the same time if you are not careful and knowledgeable you could also lose a lot of money quickly. Risk management is essential, and you should master this technique before seeking to profit from trading on margin.

Trading CFDs FAQs

How do I start trading CFDs?

Firstly, choose which market you want to trade. Secondly, find a good broker that offers trading in CFDs in that market or markets. Open an account with the broker after doing detailed research about it if they come up to an acceptable standard. Thirdly, study the market you are considering to trade, and devise a credible, profitable strategy. Then you will be ready to begin trading.

How much can you make trading CFDs?

This is a difficult question to answer with a simple number. As a trader, you should consider how much you can make in percentage terms yearly or monthly. In any type of trading you need substantial amount of money to start with in order to make good return from the financial market. Ignore get risk quick scheme and focus instead on becoming profitable over the long term.

Is trading CFDs safe?

Trading CFDs can be safe if done correctly, but it is certainly riskier than trading spot Forex due to volatility and generally larger minimum contract sizes. Of course, there is no reason why you cannot severely limit your risk trading CFDs as long as your account is adequately capitalized, and you use a reputable CFD broker.

Joe Damien
Joe has over six years of experience working within the Forex industry as a trader, writer and mentor for numerous financial companies. He previously graduated with a B.A. in Banking and Finance from Notre Dame University and went on to study a Masters in International Finance at EADA, Barcelona.

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