What is CFD trading?

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

How to Execute a CFD Trade

Here is a guide what to expect when setting up a CFD account and the things you can do to effectively manage your CFD trades.

Register an account

Select a CFD (contract for difference) trading broker, then register for an account before you start trading. The details you need to provide includes:

NameEmail Address
AddressDate of Birth
Telephone/mobile numberIdentification, e.g. passport number

You may also be required to answer the following questions:

  • How much experience do you have in trading?
  • How much knowledge do you have regarding trading?
  • How often do you trade?

Just indicate zero or none for each question if you have never traded before.

Add money to invest

Before you can open a position, or make a trade, you need to add cash to your CFD account.

Every trade uses only a small percentage of your funds when you open a position.

All CFD trades demand you to put down a deposit, also known as the margin, to help satisfy any losses on your trade.

Choose where to trade

You can trade CFDs in various markets, including:

  • Equities: e.g., Barclays, Tesco, Vodafone, and BT Group
  • Indices: e.g., Wall Street. US Tech 100, and FTSE 100
  • Commodities: e.g., silver, gold, gas, oil, wheat, sugar, and oats
  • Foreign Exchange (FX): e.g., US dollar/Canadian dollar and euro/Japanese yen

How can you choose?

Many CFD platforms provide you the option of checking the previous performance of a market before you place your bid. However, You can also look at:

  • News: Updates on economic impacts that could have an effect on your trade from news feeds worldwide.
  • Performance charts: Displays how a market has performed, from the last year based on daily readings, for example, (although this does not guarantee future success).
  • Market Information: Explains how much you can trade and other information, including the cost of any commission charges.

Make a trade

To make a trade, decide whether to go short or long on a position and the amount you want to trade.

The margin depends on the trade. You normally need a greater margin for riskier investments.

CFD trades which have a greater margin could cause you to lose a huge percentage of your money, but also have the potential to earn you a large profit.

CFD trading tools

Instead of constantly watching your trades, you can make use of CFD trading tools to help you manage your trades, for example:

  • Limit order: Once your trade approaches a certain value that displays the amount of profit that you are happy to take, this closes your position.
  • Stop loss: To dodge a huge loss, determine a value for your position to close, so your losses are only as much as you are prepared to lose.

Here is an example of how a stop loss works:

You open a trade worth 6801 on the FTSE 100,
You think the value will increase, so you go long (buy)
In case the market goes against you, you choose a stop loss at 6791
If the value decreases sharply to 6780, your position still closes at 6791, limiting your losses

Here is an example of how a limit order works:

You open a trade worth 6801 on the FTSE 100,
You think the value will increase, so you go long (buy) and pick a limit order at 6806
If the value increases to 6806, your position will close and you will earn a profit

Check your trade

Every CFD platform gives you tools to assist you in managing your CFD trades, meaning that you do not need to keep watching the performance of your trades.

To avoid big losses, make sensible trades, for example, avoid investing more because you are losing money on another trade.

Your CFD platform allows you see all of your open trades, giving you easy access to them while they remain active.

Close your trade

You can close a trade anytime, even if you have set a limit order or stop loss on it.

Once you are ready, go to where your platform enumerates your active trades then click on them to choose to close them.

You are responsible for any trades you perform, so you must understand the market you invest in if you want to increase your chances of earning a profit.

See also: What is CFD Trading