CFD trading can be a risky method and for this reason, it’s not often recommended for beginner traders or investors. Here are some of the key points covered below.
CFDs are an agreement between two parties
This is usually between a trader and a broker, with the latter agreeing to lend funds to the trader in order for them to open a position within the financial markets. At the end of the contract, they must exchange the difference between the price that the contract was opened and closed at.
You buy or sell a number of units
Your position size is calculated by how many units of an instrument you buy or sell. For every point that its price moves in your favour, you will gain multiples of the number of units, and for every point the price moves against you, you will make a loss.
CFD trading requires the use of leverage
All derivatives require traders to trade on margin (using leverage). This means that you only have to deposit a fraction of the full trade’s value in order to open a greater position, in turn giving you greater exposure to the market. This can magnify profits and losses equally.
You don’t directly own the underlying asset
What attracts traders to derivative products like CFDs is the fact that you don’t take ownership of the physical asset, whether it be a share, commodity or currency. You are simply speculating on its price movements and guessing which way it will go.
You can trade on both sides of the market
This means that if you think an asset is due to rise in value, you could place a ‘buy’ bet (open a long position). If you think the asset’s price is due to fall, you could place a ‘sell’ bet (open a short position). This differs to traditional investment where you can only use a buy and hold approach.
What are the differences with spread bets?
Spread bets are another type of financial derivative but instead of your position size being measured in units, you buy or sell a predetermined amount per point of movement, which is known as your ‘stake size’.
The two products are also taxed differently. In the UK and Ireland, spread betting is tax-free, whereas CFDs come with capital gains tax (CGT). Both, however, are free from stamp duty.
What other costs are involved?
Traders must pay the cost of an instrument’s spread, which is the difference between the buy and sell price. Most traders tend to prefer a narrower spread as this means the market is more liquid and dynamic.
Positions held overnight are subject to holding costs, which can be positive or negative depending on the applicable holding rate and direction of your position.
Commissions are also charged on share CFD trades. These usually start at around 0.10% of the full exposure of the position, as shown by UK-based derivatives broker CMC Markets, and there is often a minimum commission charge. These don’t apply to any other financial market aside from stocks.
Traders should always ensure they have sufficient funds in their account to cover all of the above costs.
How to decide if CFD trading is for you
As mentioned earlier, contracts for difference can be risky and it isn’t easy to make a profit quickly. CFD trading should not be taken as a hobby, but should rather be done with an objective in mind, using a trading strategy adapted to your individual circumstances.
Before jumping into CFD trading, most brokers would advise you to research and familiarise yourself with the financial markets, especially in volatile periods. For example, stocks and foreign exchange are two of the most popular markets to trade CFDs in, but they can see extreme price moves and catch traders off-guard.
Some brokers like CMC Markets offer traders the chance to practise using a demo account with £10,000 of virtual funds before trading on the live markets.