What Is CFD? How to Trade CFD? (Example)

In financial markets, the rules and thresholds for different financial products vary, which can make some investors feel that their options are limited. Some investors are unable to engage in short selling due to market rules, while others want to increase the leverage they use. These issues have been addressed in recent years with the emergence of CFD products, which have met many of the investors' demands. This article will introduce CFD products and discuss how to trade CFDs.

What Is CFD Trading？

A Contract For Difference (hereinafter referred to as CFD) is a financial derivative. As the name suggests, a CFD is an agreement between a buyer and a seller to exchange the difference in the value of an asset between the time the contract is opened and when it is closed.

The contract specifies that the seller will pay the buyer the difference between the contract price and the settlement price of a particular asset in cash (if the difference is negative, the buyer pays the seller). The process does not involve the physical exchange of the asset, so it can be considered an investment based on the difference between the opening and closing values of an asset.

The transaction amount in the contract is calculated by multiplying the difference by the number of units specified in the contract. The contract is updated daily and automatically rolls over each trading day. The underlying assets in CFDs can include stocks, stock indices, interest rates, or forex, and are not limited to these basic assets. The entire trading process is driven by the trader's judgment of market trends.

Pros & Cons of CFD Trading

What Are the Fees for CFD Trading？

In CFD (Contract for Difference) trading, traders must consider not only potential returns but also the fees and costs involved, as these are key factors in determining whether an investor can achieve long-term profitability. Below are some common types of fees associated with CFD trading.

Spread: The spread refers to the difference between the buy price (bid) and the sell price (ask) in forex-related transactions. In most cases, CFD brokers charge trading fees by widening the spread. Traders need to consider the losses caused by the spread when trading, as the buy price is usually higher than the sell price. Therefore, the price must move beyond the spread for the trader to make a profit.

Commission: For certain assets, CFD brokers may charge a commission as a transaction fee, such as when trading stock CFDs. This is different from forex trading, where the fees are usually included in the spread.

Overnight Financing Fee (Swap): If investors hold positions after the specified time each day, they need to pay an overnight fee. This fee is typically charged to medium- and long-term investors because CFD trading usually involves leverage, and holding a position overnight is equivalent to borrowing funds, which incurs interest. The fee may differ for long (buy) and short (sell) positions, depending on the market's swap rates.

Market Data Fees: Investors sometimes need to use tools and data provided by a particular platform, especially professional traders who may have higher requirements for data accuracy and tool sophistication. These data might require a paid subscription to access. While this fee may not apply to some traders, it is part of the overall trading costs in the long run.

Capital Gains Tax: In some countries, such as the UK and Ireland, profits from CFD trading are subject to capital gains tax. However, CFD trading is exempt from stamp duty, which can be a significant cost advantage in stock trading. Taxation methods vary by country, so each investor should calculate their costs according to their own country's tax requirements.

How to Start CFD Trading？

Step 1: Traders should first learn the basics of CFDs (Contracts for Difference) and understand how they work.

Step 2: Choose a broker with transparent trading fees and strict regulatory oversight.

Step 3: After selecting a broker, choose a CFD product that you are familiar with.

Step 4: Before engaging in live trading, register for a demo account to practice. Once you have mastered the basic functions of the trading platform and developed a solid trading system, proceed to live trading to minimize trial-and-error costs.

Step 5: After practicing with the demo account, you can register for a live account and deposit funds.

Step 6: Once you've selected a CFD product, be patient and place trades when the opportunity arises.

Step 7: Set appropriate take-profit and stop-loss orders to avoid significant losses from large market fluctuations.

Step 8: Monitor the market's progress and choose the right time to close your positions and exit the market.

Example of CFD Trading

Suppose you want to buy company X for $9/10, with a spread of 1.

You think the price of the company's stock will rise in the future, so you decide to buy 1,000 CFDs at a unit price of $10. The commission fee for buying is 0.1%.

If you buy 1,000 CFDs, you need to pay a commission fee of US$10. Assume that Company X's margin rate is 10%, which means you only need to deposit 10% of the total value of the transaction as position margin, which is $1,000.

Assume that Company X rises to $14/15 in line with expectations in the future. At this point, you decide to sell for $14 to make a profit.

Since withdrawals also require commissions, you pay a commission of 0.1%, which is $19.60. At this time, your profit is 1000×14-1000×10-10-19.6=3970.4 US dollars.

What Are the Risks of CFD Trading？

When investing in CFDs, don't only focus on the high returns but also be aware of the risks involved. The types of risks in CFD trading are as follows:

Leverage Risk: Leverage is a double-edged sword. While it can magnify profits when used correctly, excessive use of leverage without proper risk management can result in the loss of the entire principal. Investors should implement stop-loss measures before using leverage to avoid large losses.

Information Asymmetry Risk: CFDs are over-the-counter (OTC) transactions, meaning the risk of the counterparty not adhering to the contract always exists. Therefore, traders need to choose a platform with a good reputation and regulatory oversight to reduce this risk.

Non-Transparent Trading Fees Risk: Investors should closely monitor whether the spread pricing is reasonable when investing in CFDs. It's crucial to choose a platform with transparent pricing to avoid paying unreasonable trading fees.

Unlimited Loss Risk: The market itself fluctuates up and down, and the leverage in CFDs amplifies these price movements. If inexperienced investors fail to stop their losses in time and keep adding margin, they could lose all the assets in their account.

Slippage Risk: During periods of high market volatility, the actual execution price may differ from the order price, a process known as slippage. This risk is particularly significant during the release of major economic data. The better the market liquidity, the smaller the slippage. Investors should trade in markets with good liquidity.

Platform Risk: Investors should choose regulated platforms to avoid the risk of the platform going bankrupt or absconding with funds. Many unregulated platforms exist in the market, so investors need to be vigilant and choose certified, reputable brokers to avoid financial loss.

Gap Risk: Financial markets are easily influenced by major news and economic data, and the market may experience gaps when it opens after the weekend news is released. At such times, there is usually significant market volatility, so investors should monitor market trends closely and set appropriate take-profit and stop-loss orders.

Conclusion

The introduction of CFD products has increased trading opportunities in the market, but it also carries significant risks. Investors must maintain a continuous learning attitude and gain a deep understanding of the risks associated with CFDs while implementing strict risk management. Additionally, traders should be mindful of trading costs and choose brokers with transparent fee structures to avoid excessive charges from unscrupulous brokers.

FAQs

What are the differences between investing in CFD and stocks？

Investing in stocks typically requires traders to buy shares of a company. Investors can only own and profit from the shares if their prices rise in the future.

In contrast, with CFD (Contract for Difference) trading, there's no need to purchase the underlying asset. Instead, traders can participate in long or short positions on various assets such as forex, stocks, and commodities without owning them.

Which financial markets are suitable for trading with CFD tools？

CFD tools are suitable for a wide range of financial markets. These include the stock market, bond market, cryptocurrency market, commodity market, forex market, and stock indices, among others.

Which trading platform should traders choose for CFD trading？

Traders should select a trading platform that fits their individual needs. For novice traders, a platform with abundant educational resources is ideal. For short-term traders, a platform with lower trading fees is preferable, as it can enhance potential profit margins. Such as Pepperstone, FXTM, and IC Markets.

How to use CFD for risk hedging？

For example, if an investor holds a physical asset and is concerned about its short-term decline, they can use CFDs to shorten the asset. If the asset's price does indeed fall, the profits from the CFD short position can offset the losses from the decline in the value of the physical asset.