CFD (short for “Contract for Difference”) trading is a method that enables individuals to trade and invest in an asset by engaging in a contract between themselves and a broker, instead of opening a position directly on a certain market. The trader and the broker agree between themselves to replicate market conditions and settle the difference amongst themselves when the position closes. CFD trading offers many advantages that don’t exist with direct trading, such as access to overseas markets, leveraged trading, short (SELL) positions for assets which traditionally do not offer that option and more.
How do CFDs work?
- The trader chooses an asset offered as a CFD by the broker. It could be a stock, an index, a currency or any other asset that the broker has in their selection.
- The trader opens the position and sets parameters such as whether it’s a long or short position, leverage, invested amount, and other parameters depending on the broker.
- The two engage in a contract, agreeing what the opening price for the position is, and whether or not additional fees (such as overnight fees) are involved.
- The position is opened and remains open until either the trader decides to close it or it is closed by an automatic command, such as reaching a Stop Loss or Take Profit point or the expiration of the contract.
- If the position closes in profit, the broker pays the trader. If it closes at a loss, the broker charges the trader for the difference.
CFD Trading on eToro
Over the past decade, CFDs (Contracts For Difference) have become the most popular way for online investors to trade stocks, commodities, indices and currencies. As with everything that grows so fast, there is a lot of disinformation surrounding CFDs. Here we will go back to the basics to explain what a CFD is and what are its implications for traders on the eToro platform. When investing in stocks using CFDs and no leverage (1:1), the deal carries no more risk than if you were investing in the actual stock.
Most assets on eToro are traded as CFDs and are executed during specific market hours.
What’s the difference between a CFD and an ETF?
While there are similarities between CFDs and ETFs (Exchange-Traded Funds), they are quite different. The similarity is that they are both derivatives: An ETF is a fund which aggregates various financial assets into one tradable instrument, while a CFD is a contract regarding a price-change in a certain asset – meaning in both cases, you don’t actually purchase the underlying assets. However, while ETFs are composed by financial institutions following a specific market strategy (often used to hedge risk), a CFD is offered by a broker to enable access to private users. Similar to ETFs, CFD trading can be used to create a portfolio which follows a market strategy, giving the user absolute control over the assets they choose to hold, and enabling them to manage their own risks.
Can I only profit when prices are going up?
No. One of the big advantages of investing in CFDs, rather than in markets like commodities or stocks, is that you can profit from falling markets as well. Remember, a CFD is a Contract For Difference, but that difference can go in any direction. So you can invest in the possibility of prices going up (a “buy” or “long” order) or down (a “sell” or “short” order), according to what you think is likely to happen.
Is the minimum investment in a stock equal to its market price?
No. CFDs make it possible to invest smaller amounts in the markets of your choice. With CFDs you don’t actually have to purchase or own an instrument, so you are not constricted by the high prices of certain stocks or commodities. So even if the price of Google’s stock, for example, is $1,000, on eToro you can invest in Google with as little as $50 (using a leverage of 1:10) and own $500 worth of Google shares. That’s one of the greatest advantages of using CFDs.
Are there assets unique to CFDs?
Yes. Indices such as the DJ30 or the SPX500, for example, are not actual physical assets – you can’t own a piece of an index. However, with CFDs, you can speculate on index performances, which enables you to invest not just in one stock but whole sectors of national economies.
Are CFDs riskier than traditional market investments?
No. Any financial investment involves risk, and CFDs are no different. CFDs only become riskier if you’re using leverage, thereby increasing your market exposure. On eToro for example, you can invest in any asset without applying any leverage.
Are CFDs necessary for Copy Trading?
Yes. CFDs provide the flexibility that makes it possible to execute copied trades while maintaining precise proportions between the copier’s allocated funds and the copied trader’s account. For example, without CFDs, if a trader you’re copying with $100, invested a portion of his account in a stock that costs $500, you would not be able to copy this trade. However, using a CFD, you will be able to copy this trade since it enables fractional investment in an asset.