CFD Trading Guide: Contract for Differences Explained
CFD trading, or Contract for Differences to use their full title, offer traders a way of accessing a wide range of financial markets such as Stocks & Shares, Indices, Commodities, and foreign exchange. In this guide, we’ll help you to understand the most important elements of CFD trading before you decide if they are right for you.
What are Contract for Differences (CFDs)?
Contract for differences, 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.
CFDs 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 does CFD trading 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 that by purchasing a CFD, you are not purchasing that underlying security. You are simply buying a contract with your CFD broker.
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 CFD trading will often be much lower than those levied for trading physical assets, like Stocks and Shares.
CFDs 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 acess the financial markets using CFD trading.
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 CFD trading 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 CFD trading?
Trading on margin means it is possible to lose more money than your initial margin deposit if the market moves against you. Traders 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.
IS CFD trading good for beginners?
As you can probably now appreciate, CFD trading comes with plenty of risk warnings. Your profits can be magnified, which is always going to be attractive, but so too is your potential for losses. It is important that any trader starting out puts in the work to fully understand the financial markets they are planning to trade and develop a trading strategy that will maximise profits and minimise losses. You’ll find loads of fantastic free resources in our Trading for Beginners guide
The majority of CFD brokers offer demo accounts that offer traders the chance to test out their platform before they commit real money. When you have a trading strategy in place, we strongly suggest that you give your chosen platform a test drive before you begin trading for real. It is a great opportunity to test out your new strategy in a risk free environment while getting to grips with your chosen platform.
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 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.
Is CFD Trading Halal or Haram?
Muslims are typically advised to open Islamic Forex accounts that practice Shariah principles. These Islamic CFD Trading accounts, also known as swap-free accounts, are halal trading accounts in which interest is not accumulated, collected or paid. These accounts do not make use of futures and forward contracts. All transactions (including the transaction cost) take place without any delay. You can read our thoughts on whether trading is Halal or Haram and explore a small selection of regulated brokers offering permissable accounts.
