- What does CFD mean?
- How does CFD trading work
- The advantages of CFD trading
- Managing risk in CFD trading
- CFD trading FAQs
What does CFD mean?
CFD stands for contract for difference, which is an agreement between two parties to exchange the difference in a market’s price from when the contract is opened to when it is closed. You can use CFDs to trade more than 6000 global markets with us, without taking ownership of any physical assets.
CFD trading enables you to speculate on the price movement of a whole host of financial markets such as FX, indices, shares and commodities – regardless of whether prices are rising or falling. This is because you’re speculating on price movement rather than owning the underlying instrument.
How does CFD trading work?
CFD trading works using contracts that mimic live financial markets. You buy and sell these contracts in the same way that you'd buy and sell the underlying market. But instead of choosing how much of a particular asset you would like to invest in – such as 100 DBS shares – you pick how many contracts to buy or sell.
If the market moves in your favour, your position will earn a profit. If it moves against you, it will incur a loss. You realise your profit or loss when you close the position by selling the contracts you bought at the outset.
Calculating profit or loss
Just like traditional investing, your return from a trade is determined by the size of your position and the number of points that the market has moved. If you buy 100 DBS CFDs at $31 then sell them at $32, you will make $100 (100 x $1). But if the price dropped and you sold them at $30, you would lose $100.
CFD example – going long
You think the price of oil is going to go up, so you place a buy trade of five oil CFDs at a price of $53.25.
The market rises 30 points to $53.55, so you close out your position by selling your five contracts. When you close a CFD position, your profit (or loss) is the difference in the asset's price from when you opened it to when you closed it.
In this example you opened at $53.25 and closed at $53.55, so you would make $30 for each contract you bought: a $150 profit (5 x $30).
However, if the market moved against you 30 points and the price of oil dropped to $52.95, you would lose $150.
Going long vs going short
In traditional share dealing, you are buying an asset, so will only profit if the price goes up. One of the key benefits of CFD trading is that you can sell an asset if you think it will fall in value. This is known as going short and enables you to make a profit from falling prices.
Shorting with CFDs works in the same fundamental way as going long. But instead of buying contracts to open your position, you sell them. In doing so, you’ll open a trade that earns a profit if the underlying market drops in price – but a loss if it rises.
CFD example – going short
The US SP 500 is at 4,330, but you believe that it is about to fall as you expect the forthcoming US earnings season to disappoint.
So, you sell five US SP 500 CFDs at 4,330.
Your prediction is correct, and the US SP 500 falls to 4,280. When you sell CFDs, you’re still agreeing to exchange the difference in an asset’s price, but you earn a profit if the market falls and a loss if it rises.
The US SP 500 has fallen 50 points, so you earn $50 for each of your five contracts – a profit of $250.
But what would have happened if the index had risen 50 points instead? You would lose $50 for each of your five CFDs, a total loss of $250.
Buy and sell prices
You’ll see two prices listed for every CFD market: the buy (or quote) price and the sell (or bid) price. To open a long position, you trade at the buy price. To go short, you trade at the sell price.
When you want to close, you do the opposite to when you opened. So, if you’d bought, you would sell. If you’d sold, you would buy.
The buy price will always be slightly higher than the market’s current level, while the sell price will be a little bit below it. The difference between the two is called the spread and is usually how you’ll pay to open a position.
There is one significant exception to that rule. With share CFDs, you pay a commission to open your position – just like when you buy physical shares with a stockbroker.
Choosing your deal size
As we’ve already covered, you decide the size of a CFD position by setting the number of contracts you want to buy or sell.
The size of a single CFD will change depending on your asset class. With equities, for example, buying one contract is the same as buying one share. With forex, it is the equivalent of a single lot.
You can learn more about lots here.
What is leverage in CFD trading?
CFD trading is a leveraged product, which means you can open a trade by depositing just a small fraction of its total value.
In other words, you can put up a small amount of money to control a much larger amount, giving you much larger exposure to the market you’re trading. This will magnify your return on investment, but it will also magnify your losses. So, you should make sure to manage your trading risk accordingly.
Let’s return to our oil example above to see how this works in practice. Buying five oil CFDs at $53.25 would give you a total position size of $266.25 (5 x $53.25). Because CFD trading is leveraged, you would only have to put up a fraction of that, known as your margin.
If oil requires a 20% margin, then you’d only need to pay 20% of $266.25 to open your trade: $53.25.
The advantages of CFD trading
You can trade on falling markets as well as rising ones, without borrowing any stock.
By using a small amount of money to control a much larger value position, you don’t have to tie up lots of capital.
As CFDs allow you to short sell, they are often used by investors as ‘insurance’ to offset losses made in their physical portfolios. This is known as hedging.
For example, if you hold $5,000 of DBS Bank shares and you are concerned that they are due for an imminent sell-off, you can help protect your share portfolio by short selling $5,000 of DBS Group Holdings CFDs.
Should DBS Bank share prices fall by 5% in the underlying market, the loss in your share portfolio would be offset by a gain in your short trade. In this way, you can protect yourself without going through the expense and inconvenience of liquidating your stock holdings.
Which instruments can I trade?
City Index offers a choice of over 6,000 CFD markets, including:
- The world’s leading Indices such as Wall Street, the US SP 500, the Germany 40 and the Singapore Index
- Over 80 Currency pairs including, EUR/USD, GBP/USD, AUD/USD
- Global shares including DBS, Apple and Tesla
- Commodities such as oil, gold and silver
Is CFD trading right for me?
CFD trading enables you to:
- Take advantage of leverage
- The ability to sell as well as buy markets
- Trade a range of markets like shares, indices, commodities
- Hedge a share portfolio
This makes it an attractive trading product for many traders.
It is important to ensure you understand the risks associated with CFD trading before making your first trade. You can try trading risk-free with the City Index demo trading account.
- Looking for short-term opportunities
CFDs are typically held open for hours, a few days or sometimes weeks, rather than over the longer term.
- Who want to make their own decisions on what to invest in
City Index provides an execution-only service. We will not advise you on what to trade or trade on your behalf.
- Looking to diversify their investment portfolios
City Index offers over 6,000 global markets to trade on including shares, commodities and indices.
Managing risk in CFD trading
As CFDs are leveraged, it’s a good idea to manage your risk carefully when trading them. Two key trading tools to help control risk are take profit orders and stop losses.
Take profits – also known as limit orders – will automatically close your position if it hits a certain profit level. In doing so, they help you stick to your trading plan when you may be tempted to hold onto a winning position, despite the risk that the market may reverse.
Stop losses also automatically close your position, but they do it once it hits a specified level of loss, limiting your total risk from any given trade. However, standard stop losses aren’t 100% effective as they can be subject to slippage if your market ‘gaps’ over your stop.
To ensure that your position will always close if your stop level is reached, you’ll need to upgrade to a guaranteed stop loss order (GSLO).
Learn more about CFD trading risks.
CFD trading FAQs
What is the difference between CFDs and futures?
While they are both derivatives – financial products that enable you to speculate on markets without buying assets – and both take the form of a contract, CFDs and futures work very differently in practice.
When you buy a future, you are agreeing to trade a set amount of an asset at a set price on a set date (known as the expiry). If you hold a future when it expires, you’ll have to either buy or sell the underlying market – whether it’s oil, gold, forex or shares.
With a CFD, you are agreeing to exchange the difference in an asset’s price from when you opened your position to when you close it. You’ll never have to take ownership of the asset itself.
Does a CFD expire?
Daily CFDs don’t have expiry dates, while forward CFDs will expire on a set date in the future. You can choose whether you want to trade a CFD that expires or not.
Daily CFDs are mostly intended for shorter-term positions, as they will incur overnight funding charges when held open for more than one day. Forward CFDs have these charges included in the spread, so may be more cost effective if held open over the long term.
Do day traders trade CFDs?
Yes. The leverage and range of markets available with CFDs make them a popular option among day traders:
- Leverage magnifies profits and losses, which can be useful when trading relatively small price movements
- The range of markets helps day traders save time, accessing thousands of trading opportunities from a single login
Should I trade CFDs or invest?
CFDs and traditional share investing are two very different products that suit different trading styles. CFDs, for example, can offer profits over a shorter-term horizon than investing – but they can also be riskier.
Many investors have share portfolios while also trading CFDs.
Read more about CFDs vs share dealing here.
Can you trade shares CFDs actively on an intraday basis?
There are no limits to how many times you can buy and sell the same stock with a CFD. Depending on your trading strategy, if you have a view on intraday market movements, shares CFDs allow you to open and close positions on the same market multiple times within a single trading day.
Find out more
- Learn how to start trading CFDs
- Explore the risks of CFDs, and how to mitigate them
- Follow some in-depth CFD trading examples
Next chapter CFD trading example