CFD trading: what is it, how does it work, and what are the risks?
What is a contract for difference (CFD) trading? What are the pros, cons and associated risks? What’s the best CFD trading platform? This article answers these questions, giving you a comprehensive look into CFD trading.
What is Contract for Difference (CFD) trading?
A contract for difference, or CFD, is a type of financial contract common in investing and trading. When two parties enter a CFD, an agreement is made to pay the difference between an asset’s current value and its value at contract time.
The CFD broker pays the investor if the closing price at contract time is higher than the opening price at purchase time. If the opposite is true, and the asset has decreased in value, the investor may need to purchase an offsetting trade to cover this.
In many ways, CFD trading is similar to futures trading, a concept you may have encountered before. However, futures are traded on the stock exchange, while CFD trades happen more directly. Plus, CFDs tend to be more accessible and don’t have the same rules surrounding expiry dates and quantities as futures.
How do CFDs work?
CFDs are cash-settled, ideal for short-term trading of securities. As a CFD investor, you don’t own an underlying asset. Instead, you earn money from Exchange-Traded Funds (ETFs), stock indices and commodities based on their changing price.
Taking gold as an example, you’re not buying or selling the precious metal itself. Instead, you’re speculating on whether the price of that gold will go up or down in a given timeframe. You’re trading in price movements.
CFD trading is considered an advanced strategy and primarily recommended to experienced investors, partly because it can be challenging to get your head around and partly because it requires careful and calculated risk assessment. As a CFD trader, you’re constantly making bets on whether the underlying asset or security price will rise or fall.
If you’re interested in getting involved with this type of trading but unsure where to start, we’d recommend speaking with an experienced financial adviser before making any definitive moves.
How much does a CFD cost?
The cost of a CFD itself is hard to define since it depends entirely on the pricing of the underlying asset or security. There are, however, CFD fees you’ll need to be aware of, and these should form an essential part of determining whether this might be a suitable investment route for you:
CFD commission fees are applicable to share CFDs when opening and closing (but not to indices, currencies, commodities and bonds).
Overnight financing fees are applicable when you want to hold a CFD for more than one trading day.
The Guaranteed Stop Loss Order (GSLO) charge is applicable if you’d like to guarantee your ability to exit a trade at a certain value.
Taxation in line with US law on any dividends paid from CFD trading.
The five best CFD trading platforms
Finding the right CFD platform can be challenging, given that many options exist.
It is highly recommended to choose providers who are authorized and regulated. Some popular platforms include:
What are the advantages and disadvantages of CFD trading?
CFD trading does have its advantages and disadvantages, including:
CFDs allow investors to trade in price movement without taking full responsibility for an asset's price.
CFDs are incredibly varied, presenting investors with many potential routes and options.
CFD trading risks can be controlled, in part, by provisions like the GSLO (Guaranteed Stop Loss Order) mentioned above.
There’s a high risk of losing money on a CFD trade, especially for less-experienced investors.
CFD trading regulations and fees can create a lot of red tape for traders to sort through.
Using CFDs as the basis for leverage on a bigger deal can increase your vulnerability to exponential losses.
Overall, the risk of trading in CFDs should never be understated, especially for beginner investors.
Oppositely, the potential reward associated with trading in CFDs and using them as leverage where appropriate cannot be forgotten.
Is CFD trading your next step?
While exciting opportunities are available in this area, considerable risks must first be addressed and adequately understood.
For quality investment advice, whether it concerns CFD trading or any other route you plan to take, it’s best to speak with a financial adviser. Find one today with Unbiased.
Senior Content Writer
Rachel is a Senior Content Writer at Unbiased. She has nearly a decade of experience writing and producing content across a range of different sectors.