What is a CFD?

CFD Education

A CFD is a contract is between a trader and a broker, based on the difference between the price points where you enter and exit a trade. Depending on where the exit point sits relative to your entry point, you will make a profit or loss. 

Types of CFDs

CFDs are known as derivatives because their value is derived from the real value of a separate asset like a stock or commodity. There are several categories of CFDs.

Share CFDs

The most commonly traded CFDs involve shares or stocks. Ordinarily, when you trade stocks you are buying into a company and your profit will depend on that company improving its stock price. But with share CFDs you do not own stock and are simply trading on the price movement of those stocks, either up or down.

Commodity CFDs

Commodities are basic goods that have been used in commercial trade as part of the global production chain, in many cases for hundreds of years. They include raw materials, primary agricultural products, base and precious metals, crude oil and more.

Commodity CFDs give you the opportunity to trade on the movements in these factors of production or stores of wealth without the need to take, or make, physical delivery of the commodity specified.

You can trade a uniform amount of the specified commodity, with a maturity date at a certain point in the future – or at least a rollover date – without the need to physical take receipt of the commodity. In other words, you’re not buying or selling a physical good, for example a kilogram of gold, a barrel of crude oil or a warehouse full of copper. All you’re doing is trading on the real price movements of the commodity in the market, in whatever direction you want.

Index CFDs

Individual stocks trading on global exchanges are usually grouped into some kind of index. Think of the names you are familiar with; The Dow Jones, NASDAQ, Nikkei, FTSE and S&P. The ASX (Australian Securities Exchange) – or SPI 200 as the CFD is known – is the local version of these big global indexes.

Because they group the shares of their constituent companies, Indexes are an effective way to measure the collective value of certain sections of the stock market. For example, the Dow Jones represents 30 large publicly owned companies based in the USA; the Nikkei represents the top 225 blue-chip companies on the Tokyo Stock Exchange; the SPI 200 represents the top 200 companies on the ASX, the China A50 represents the top 50 companies in China and the Eurostoxx 50 represents the top 50 companies in Europe.

As we know, CFDs do not require the purchase of an asset, so when you trade Index CFDs you are simply following the price movement of the index as it rises or falls.

Advantages of CFDs

Why would you trade CFDs when you could invest directly in an asset? It’s often a matter of convenience.

Less margin requirements

If you wanted to buy 100 shares of stock valued at $12, you would need an up-front investment of $1,200. On the other hand, if you were to trade that same stock as a CFD, you would be able to use leverage to reduce the initial margin requirement. Because you are able to use leverage up to 400:1 you can reduce your initial outlay considerably. However, raising leverage does come with a higher level of risk.

Wider access to markets

In addition to the initial outlay required, in some cases – such as geographical, political or legal restrictions – you may not be able to buy certain stocks or commodities even if you wanted to. Because CFDs do not involve asset ownership, brokers are able to offer a larger suite of global instruments to trade from anywhere.

Lower fees

Because each broker has a different fee structure and each trader trades with different amounts and frequencies, it’s difficult to say what is the most cost-effective method for every situation. However, CFD trading does tend to have fewer fees when compared, for example, with traditional stocks, which has made it increasingly popular. A simple calculation of basic benefits and costs should make it clear which is the better method for you.

Risks of CFDs

The main risk attached to CFD trading relates to leverage. When you use leverage to trade, you’re exposing yourself to greater levels of risk and, if trades go against you, you may find you lose more than your initial investment.

Like any form of trading, CFDs should not be viewed as a get rich quick scheme. It requires knowledge, skill and a high level of involvement. Diversification and spreading trades across different instruments can help mitigate risk and avoid a ‘putting all you eggs in one basket’ scenario.

CFD Trading Strategies & Tips

Every CFD trader will have their own objectives, meaning no one strategy can suit everyone. However, there are some general tips that apply to anyone wanting to trade CFDs.

Stop Loss

If you’re not using a Stop Loss, you’re not trading responsibly. This is a safety net in the event that markets conditions work against you and it will help protect your account to some degree. The tool is built in to the MT4 trading platform so there’s no excuse not to put it in place.

Money Management

You should always be aware of the capital you have available and be sure to retain a sufficient base to meet your goals and, in the worst case scenario, cover any losses. This goes hand in hand with risk management.

Risk management

Never trade more than you can afford to lose. Your overall strategy should contain realistic limitations on leverage, trade size and capital outlay. No one knows your situation and capabilities better than you do, so come up with some appropriate guidelines that balance risk with your end goal and adhere to them as much as possible. In trading, you are the sole person in charge of your account, so you are also responsible for managing the amount of risk you expose yourself to.

Position Size

Defining a strategy will help you guide you towards making trades of an appropriate size and, in turn, help to ensure you don’t overreach by trading too big. The trade sizes you feel are appropriate will be dependent on your available capital and approach to risk

Trade analysis and monitoring

Regularly monitoring the markets will put you in a better position to take action on trades, if any is needed. This is especially important if you are using high leverage where small changes can lead to big losses. In those cases, immediate action can make a big difference. Post-trade analysis of all your trades is equally important as it helps you see the things you do well, along with those things you don’t do so well.

Differences between CFDs and Forex

In general, and in practice, you should find the act of trading Forex and CFDs quite similar. Both are available to trade on the same MT4 platform, but there are differences between the two instruments. For starters, there are more CFDs offered in more exchanges than what is available in Forex currency trading.

But each instrument, Forex pair, individual index and CFD behaves differently when they are trading. Because of the factors affecting the pricing of the different instruments, there are differences in the way markets behave and their volatility. For example, Forex is driven more by economic and monetary factors while CFDs are affected more by supply and demand, including seasonal variation. You may find that there are different trading costs associated with CFD trading and Forex, though this will depend on the broker and the specific costs applicable to your own trading account.