CFD trading enables you to find trading opportunities across shares, forex, indices, commodities and more. In this step-by-step guide, we’re going to cover all the fundamentals of CFD trading, so you can decide whether you want to start buying and selling contracts for difference yourself.
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What does CFD mean?
CFD means 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 them to trade 1,000s of global markets, 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 indices, shares, currencies, commodities and bonds – regardless of whether prices are rising or falling. And because you are speculating on price movement rather than owning the underlying instrument, you will not pay UK Stamp Duty on any profits*.
* Spread betting and CFD trading are exempt from UK stamp duty. Spread betting is also exempt from UK Capital Gains Tax. However, tax laws are subject to change and depend on individual circumstances. Please seek independent advice if necessary.
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 HSBC shares – you pick how many contracts to buy.
If your 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 1,000 HSBC CFDs at 400p then sell them at 450p, you will make (1,000 x 50p) £500. If you sold them at 350p instead, you would lose £500.
CFD example – Going long with CFDs
For example, say you think the price of oil is going to go up, so you place a buy trade of five oil CFDs at its current price of 5,325.
The market rises 30 points to 5,355. You close out your position by selling your five contracts. When you close a CFD position, you exchange the difference in the asset's price from when you opened it (5,325) to now (5,355).
The difference is 30 points, so you would make $30 for each contract you bought: a $150 profit (5 x 30).
However, if the market moves against you instead, then you would have to pay the difference to your provider. So if the price of oil falls 30 points to 5,295, you would lose $150.
Going long vs going short
In traditional share dealing, you can only buy markets, which opens a long position. 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 4,200, 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 4,200.
Your prediction is correct, and the S&P falls to 3,275. 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 500 has fallen 65 points, so you earn $65 for each of your five contracts – a profit of $325.
But what would have happened if the index had risen 70 points instead? You would lose $70 for each of your five CFDs, a total loss of $350.
Buy and sell prices
You’ll see two prices listed for every CFD market: the buy (or ask) 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. The difference between the two is called the spread, and is usually how you’ll pay to open a position.
What is leverage in CFD trading?
Leverage in CFD trading is a tool that enables you to open a position 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. This will magnify your return on investment, but it will also magnify your losses. So you should make sure to manage your risk accordingly.
Let’s return to our oil example above to see how this works in practice. Buying five oil CFDs at 5,325 would give you a total position size of (5 x 5,325) $41,625. Because CFD trading is leveraged, you would only have to put up a fraction of that, known as your margin.
If oil requires 10% margin, then you’d only need to pay 10% of $41,625 to open your trade: $4,162.5.
The advantages of CFDs
CFDs are a popular way for investors to buy and sell a range of financial markets, bringing several benefits for active traders:
- Tax efficiency*
You are not required to pay UK Stamp Duty
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
Plus, they can be a great tool for hedging.
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 Barclays Shares and you concerned that they are due for an imminent sell-off, you can help protect your share portfolio by short selling £5,000 of Barclays CFDs.
Should Barclays 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 1,000s of CFD markets, including:
- The world’s leading indices: the FTSE 100 (UK 100), Dow Jones (Wall St), DAX 40 (Germany 40) and dozens more
- GBP/USD, GBP/EUR, EUR/USD and 80+ more FX pairs
- Global Shares such as Tesla, Amazon and Apple
- Commodities including oil, gold and cocoa
- Other markets such as bonds, interest rates and options
Managing risk in CFD trading
As CFDs are leveraged, it’s a good idea to manage your risk carefully when trading with them. Two key tools to help control risk on each trade are take profits 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 plan when you may be tempted to hold onto a winning position, despite the risk that it may reverse.
Stop losses also automatically close your position, but they do it once it hits a specified level of loss. They help limit 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.
Learn more about CFD trading risks.
Spread betting vs CFD trading
Like CFD trading, spread betting enables you to open leveraged buy or sell positions on a range of markets without taking ownership of any assets. But these two leveraged products work in slightly different ways.
Instead of buying or selling contracts, when spread betting you bet a set number of pounds per point on the direction in which a market is headed. Your profit will increase for every point that the market moves in your direction, in which you think a market is headed.
Learn more about the difference between spread betting and CFDs.