Here’s our guide to Contracts for Difference, also known as CFDs. We’ll help you to understand:
So, What are Contracts for Difference?
Contracts for difference, or CFDs, are contracts for a specified financial instrument that are held between an investor and their broker or investment bank.
At the end of the contract, the parties exchange the difference between the opening and closing prices of the instrument resulting in a profit or loss for the investor, depending on the outcome.
Contracts for Difference offer the investing public the opportunity to trade financial markets using something called leverage.
Leverage means you only need to commit a portion of your total trade value (usually between 1% and 10% but sometimes higher).
This is called your margin. The rest of the value of the trade is loaned to you by your CFD broker. While you are only trading with a fraction of the money you might ordinarily require, you get to keep all the profit – or the loss – you make on the trade.
How do Contracts for Difference work?
CFDs represent one of the most cost-effective ways to trade the most popular financial markets from a single platform.
The price of the CFD you are offered is based on an underlying derivative contract or other security. It’s like buying a share, currency pair, bond or financial index. The difference is by purchasing a CFD you are not purchasing that underlying security. You are simply buying a contract with your CFD market maker.
This means you don’t need to worry about any of the costs associated with shares and other financial market assets.
In addition, commissions charged for trading CFDs will often be much lower than those levied for trading physical assets, like stocks and shares.
Contracts for Difference and Social Trading
Over the last few years, we’ve seen the introduction of a number of social trading brokers to the industry. They offer a completely different way to trade the financial markets using Contracts for Difference.
Rather than choosing to trade an individual CFD, investors can view the trading behaviour of successful traders. If they like the way they trade, traders can replicate those positions through their own account.
This concept is known as Copy trading. It offers investors the opportunity to piggy-back on the positions of experienced traders, within a budget that suits.
Of course, this alternative method of trading Contracts for Difference is not without its risks. However, it can provide a useful introduction to trading for inexperienced investors, particularly when this method is adopted through a social trading virtual account.
What are the risks associated with Contracts for Difference?
Trading on margin means it is possible to lose more money than your initial margin deposit if the market moves against you. Investors are encouraged to use a stop loss to protect themselves against heavy losses.
A stop loss is a sell order which will close your position automatically once it passes a certain point. As you gain experience, you’ll begin to get a feel for where your stop losses should be placed. Setting out your trading strategy is often a big help in determining your overall goals. Feel free to use our 11 steps trading strategy guide as a basis from which to develop your own strategy.
If you do not live in the UK or Republic of Ireland – where you can benefit from tax free spread betting accounts, CFDs are arguably the best option for trading multiple financial markets from a single account.
Unfortunately, CFDs are currently not available for sale in the United States, although they are authorised in some Canadian provinces.
Opening a Contracts for Difference account
The majority of Contracts for Difference brokers offer demo accounts, providing traders with the chance to test out their platform before they commit real money. We strongly suggest that you give your chosen platform a test drive before you begin trading for real. Before you start looking at brokers, download our free guide to choosing your CFD broker. It will give you a fantastic insight into how Contracts for Difference brokers operate and how you can use this to choose the broker that best fits with your trading objectives.
You can find a full list of the best CFD trading platforms here. Navigate further and we’ll provide you with a detailed review of each broker and, most importantly, our impartial view on their products and services.