CFD Trading Frequently Asked Questions

General CFD Trading Questions

Contracts for difference, or CFDs, are instruments traded between traders and brokers to settle on the difference in the price in an underlying market. They are, as the name implies, contracts for difference in the value in the underlying market between the price today and the price when the position is closed. In many respects, CFDs work functionally the same as a share transaction, or buying any other instrument in cash markets, except for a number of key legal differences and the role of margin and leverage which both come into play when trading CFDs.

When it comes to CFDs, it's all about leverage. Leverage is the key component of trading CFDs, and in many respects it's leverage that sets CFDs apart from many other instruments. Leverage is the ability to amplify the size of your positions artificially, with a little help from your broker. Leverage is effectively short-term, temporary finance provided by the broker which gives you access to larger transaction sizes, and therefore greater percentage returns on your capital. So, instead of 100 getting you 100 of shares, your 100 might get you 2000 worth of CFDs, simply because of the impact of leverage. While the remaining 1900 still has to be paid back at the end of the transaction, any profits made on the 2000 are banked in addition to your original 100 investment. This totals up to make CFDs wildly more profitable than most other market instruments.

For leverage to operate smoothly, traders are expected to deposit and maintain a certain percentage of the overall transaction size as security against any leverage offered. This is known as the margin requirement, and is effectively the buy-in rate for the CFD trader. Usually, margin requirements are around the 5% mark, which affords leverage to a factor of 20, although this varies depending on the exact market and the climate in which you're trading.

If your broker's margin requirement stands at 5%, this share of the transaction size must always be maintained. So, if the value of your position decreases and your 5% effectively becomes worth 4%, you will be required to fund the additional percentage point in order to meet this minimum requirement. If you fall below this threshold level, you will be required to stump up the extra funds and you may even experience the margin call - a demand from the broker for funds that has the effect of closing other open positions to liquidate your portfolio. This can naturally strangle off otherwise successful positions, and can end up costing you heavily, so it's best avoided at all costs by keeping sufficient reserve capital in your account.

Leverage and margin work by having the effect of increasing your resources. A 100 trade that moves 1% sees the same percentage return as a 10000 trade that moves 1%, but the latter obviously equates to more money. This means that with leveraged CFDs, you can enjoy greater returns from the same trades than would otherwise be the case, although this does present a substantially higher risk profile than might otherwise be the case.

CFDs are taxed as a sort-of half-way house between spread betting and share dealing, which in this context represent the extremes of tax-efficient and tax in-efficient respectively. CFDs are not tax free, and any positions that are closed are potentially liable to capital gains tax in the UK (assuming you earn more than the annual exemption level of around 10,000 from your CFDs). However, CFDs don't attract stamp duty as with share transactions, so therefore represent a cost saving on buying shares.

Getting started trading CFDs is technically simple, but doesn't come recommended until you have thoroughly researched how it works, how it's done, and the markets you intend to trade. Assuming you've done all that, getting started is as simple as signing up for a trading account with a broker, depositing your capital and picking your first trade. However, it's highly beneficial to firstly open several demo accounts across the industry, using the opportunity to try out different platforms and work out your trading strategies and theories before testing them out in the market for real. This will save you money, and is crucial to learning how the markets really work.

Profits in CFDs are made by banking a positive difference between opening and closing price (or a negative difference if you're going short), then deducting commission, financing costs and repaid leverage to show a return on capital. For traders who are going long, i.e. backing a CFD to rise in price, the CFD must become more valuable over time than when they bought it by a sufficient percentage to offset other costs in order for a profit to be made. The reverse is true of short positions, which rely on the closing price being lower than the opening price in order for a profit to be realised.

CFDs are relatively cost effective to trade, particularly if you're trading intraday. Each CFD transaction is charged a rate of commission by the broker, applied as a percentage to the total trade value. Then, financing costs are applied to cover the cost of leverage on a daily basis, accruing overnight at LIBOR +/- X (where X equals the broker's own variable), divided by 365 to give a daily rate of interest. Of course, if your position loses, you also have to worry about the costs of repaying leverage, which can have the impact of making any losses feel all the more substantial.

Of course. In fact, the vast majority of traders lose with CFDs over time, simply because they are unable to commit the time, energy and capital to learning how the markets work in practice. Added to which, the high degree of leverage means that while profits are handsomely rewarded, even incremental losses can really start to smart. Making a loss from CFDs is perhaps easier than making a profit, so its important to make sure that you hard wire risk management strategies into your trading portfolio to minimize their impact.

CFDs are extremely risky. While much is written and spoken about the rewards trading CFDs can bring (all of it true), there is unfortunately (and for obvious reason) less spoken about the downsides. No one wants to ruin the party by bringing up the varied risks and threats posed by CFD trading, but it's crucial that you're aware of these factors before you commit your capital. CFDs are always highly leveraged, which means that even if positions go wrong you're still liable for the amount you borrowed in leverage.

Added to which, often extremely volatile markets can make it difficult for traders to avoid losing from time to time. The trick is to manage the risks posed by CFDs, and the trader who manages to reduce their risk profile stands a better chance of profiting over time.

CFDs are priced on the basis of the market rate plus or minus a weighted factor that the broker will include to more accurately reflect its impression of where the market is likely to go. While CFD prices roughly track underlying market prices, this added element makes them less transparent than exchange traded CFDs, or than alternative instruments which more closely follow market price. For some traders, this problem causes them to sacrifice a degree of liquidity for a move into DMA CFD trading, where positions are opened directly on market exchanges rather than through the broker who explicitly agrees to fill orders and make markets. This corrects the often marginal price discrepancies in CFDs as compared to underlying cash markets.

CFDs are equivocally not gambling. Trading in CFDs is more akin to trading in shares or other 'respected' securities than even financial spread betting, and while the two are often lumped together for their high risk, high return characteristics, both have something to offer the open-minded trader. In gambling, much of the outcome is out of your hands. A horse could break its leg or a thunderstorm could cause make difficult playing conditions which in turn jeopardizes your bet. With CFDs, while the risks are vast, there are measurable underlying factors that can be researched and interpreted much more closely than in sheer gambling where chance plays a much more significant role.

With CFDs, both earnings and losses are totally unlimited, unless you choose to limit them. With earnings, positions that keep rising (or falling, depending on whether you've sold short) can theoretically do so forever or until the markets have nothing more to give. For CFD traders, that means there is the real possibility of hitting the home run trade that just keeps growing and growing - albeit a very slight possibility. That means your capital can keep on earning you more and more money from successful positions, and assuming you can afford the costs of rolling the position overnight, you can keep a position open indefinitely to realize the full extent of your profits.

CFDs are used to trade a wide number of instruments and markets, many of which are not normally accessible through a particular instrument or trading vehicle. For example, CFDs can be traded on FTSE 100 shares, or even the FTSE 100 index itself. They can be traded on commodities like gold, rice, pork bellies or soya, or they can be traded on currencies or interest rates or bond rates - essentially, anything that is a market or an index can be used as the basis for trading contracts for difference, and as a result traders have access to a wide range of different trading options and markets through their broker.

CFD Brokers And Trading Accounts

Demo accounts are without doubt one of the most vital tools for successful CFD traders. As a beginner, nothing gives you the same degree of education as a demo trading account, where you can trade the markets for real but with virtual money. Even for the more experienced trader, testing out new strategies in the sandbox that is a demo account provides security and a totally risk-free environment to try out new things. While of course, real accounts are what actually make you money, much of the learning phase can be handled through demo account trading, which means you don't spend a penny until you're ready.

CFDs are regulated by the Financial Conduct Authority in the UK as financial instruments. They are also regulated at European level with a number of EU directives seeking to even the playing field throughout the region, but rest assured that an FCA-authorised and regulated broker must meet strict compliance obligations in order to continue trading unimpeded. Therefore, it is usually enough to confirm that your CFD provider is legitimately regulated by the relevant body to safeguard your dealings with them.

CFD Trading Strategies

There are a number of different strategies for trading CFDs and settling definitively on one that generally delivers the best results isn't possible. Devising a strategy that works for you is the only way to work out how to trade CFDs strategically going forward, and depending on the markets you are trading and the research methods you favour, your approach to trading CFDs may well be unique. Having said that, whatever strategy you deploy, it's vital that you make sure that profits are allowed to run and that losses are cut short. Regardless of the finer points of your strategy, this overarching aim will seem you right as you scramble to deliver an aggregate profit.

The risks of trading CFDs are posed largely by the risk of being exposed to the markets, so the best way to trade from a risk perspective is to keep your market exposure to a minimum. At the same time, this presents a key problem for traders - without market exposure, you can't make money, so the best risk management strategy lies somewhere in the middle. While stops can be a useful tool in helping you minimize losses on individual trades, much of the risks of trading can be reduced through careful, thorough research and through devising a sensible strategy.

CFDs vs Other Investments

CFDs can be bought in shares in much the same as shares can be bought and sold. If the value goes up, both CFD and share traders will make profits on long positions. However, the CFD trader doesn't at any point come into ownership of any shares - he is in fact only the owner of a contract for the difference in value, made with the broker. This has tax saving advantages in the first instance, and allows margin and leverage to be worked in to best effect in CFD transactions. So, 100 spent on exactly the same transaction with the same shares through cash and CFD markets will yield a substantially higher return through CFDs than were the shares traded themselves directly.

CFDs and spread betting are often compared directly because they have a number of key similarities - namely that both are highly leveraged and can as a result return significant sums from incremental market movements. But while they may have some practical similarities, they also have key differences. Spread betting for many professional traders has something of a stigma attached - it is considered little more than a gambling activity. While that's not strictly the case, spread betting does bear little resemblance to the underlying market price, whereas CFDs are at least more notionally traded on the basis of underlying prices.

While spread betting is seen as an extra-market transaction, CFDs are seen as part of the market and more of a financial transaction than financial spread betting. While there are practical differences, both instruments are of course useful for investing in a range of markets with highly leveraged positions.