You can trade in CFDs across various global financial markets. However, understanding the risks can help you to avoid big money losses. Here is a guide on how CFDs work and how to begin trading.
What is it?
A Contract for Difference (CFD) is a leveraged investment which means that you do not need to commit all your money on a single trade.
Also known as trading on margin, you only need to place a percentage of the trade to open your position, which is normally between 0.1% and 1%.
This offers you the flexibility to spread your investments over numerous trades in various markets, such as:
- Foreign exchange
- Shares in companies
- Indices, such as the FTSE 100
- Commodities, such as gold and silver
How does it work?
When you make a trade you receive two prices, the buy price, and the selling price:
If you think a value will increase, you could go long and buy some CFDs
If you think a value will decrease, you could go short and sell some CFDs
The difference between the prices of the two is known as the spread. To earn profit, you must close your position after the price has moved more than the value of the spread.
For example, if the purchase price for the FTSE 100 is 6801 and the selling price is 6800, the cost would need to grow by more than 1 point* to make you a profit.
How does the spread work?
When selecting a CFD trading platform, the main thing to look out for is the spread’s size.
The smaller the spread of the CFD, the smaller the market movement demands to be to be able to give you a profit, for example:
- Platform A has a sell/buy price worth 6800/6801 (one point spread) on the FTSE 100. The market would need to increase by two points to give you a profit.
- Platform B has a sell/buy price worth 6798/6801 (three-point spread) on the FTSE 100. The market would need to increase by four points to give you a profit.
What is the margin?
It is the amount you need to place to open your CFD trade. It is different between various CFD companies.
For example, if the margin for a trade is 1%, and you want to purchase 100 FTSE 100 contracts with a sell/buy price of 6800/6801, you will need a deposit of £68.01 (1% of 6801).
The margin serves as a deposit which satisfies some of your losses if the trade works against you.
Your losses could still surpass your deposit, so make sure you understand the risks involved before you begin trading.
How can you earn a profit?
When you perform a CFD trade, you buy a number of contracts. If the market moves in the direction that you predict, you could earn a profit.
Below is an example of how a CFD trade could make or lose your money:
The sell/buy price for the FTSE 100 is 6800/6801, meaning each contract at the selling price is worth £6,800, or £6,801 for the buy price, you purchase five CFDs, the cost of the trade would be worth £34,005 (5 CFDs x £6801)
You only need to put down a 1% margin to open your trade, worth £340.05 (1% of £34,005)
To earn a profit, the selling price needs to be more than the buy price that you bought your CFD:
You sell your five CFDs when the sell/buy price is 6806/6807
Multiply the selling price by a number of CFDs to give you £34,030 (5 x £6806)
Deduct this amount from your original contract value, £34,030 minus £34,005, and you have a profit of £25
If the selling price is below the amount that you bought your CFDs at, you will make a loss, for example:
You sell your five CFDs when the sell/buy price is 6796/6797
Multiply the selling price by a number of CFDs to give you £33,980 (5 x £6796)
Subtract this amount from your original contract value, £33,980 minus £34,005, and you have a loss of £25
What are the fees to be applied?
Here are some other charges you may find when trading CFDs:
- Overnight trade interest charge: CFD companies set an interest charge of around 1.5% for any trades you leave open overnight.
- Inactivity fee: If you have not yet traded for a set term, such as two years, you could face a monthly charge of around £12 until you close your account or start trading again.
- Funding/withdrawal fee: Companies charge you to withdraw or add money to your account, such as a set fee of £5 for every £200.
Do you have to pay tax?
You do not need to pay income tax or stamp duty when you invest in CFD trading.
In a single tax year, if your profits exceed £11,300 (6th April until the following 5th April) you have to pay Capital Gains Tax.
However, you can opt to offset any Capital Gains Tax with any losses that you make when CFD trading.
What to do next
Listed below are some top tips to follow before trading in CFDs:
- Do not make trades until you have taken the time to study the market, and make sure that you only trade the amount of money you can afford to lose.
- Open and make use of a demo account to familiarise yourself with your chosen platform
- Do not perform an emotional trade, like if you want to make up from any big losses
- Only make trades on markets you understand
See also : How to Execute a CFD Trade