Are you new to the concept of trading CFDs? Desperate to ask the question what does CFD stand for? You’ve landed on the right page. Within this beginner’s guide to CFD trading, we’ll explain the meaning of CFD, how CFD trading works and why it’s becoming an increasingly popular way to trade. We’ll even explore the trading features exclusively available to CFDs that can help to manage your risk and maximise profitable positions in the market.
To conclude this CFD trading for beginners’ guide, we’ll also equip you with several CFD trading tips and strategies to adopt, including choosing a reputable CFD broker and testing CFD trading strategies using virtual demo accounts before committing your hard-earned money upfront.
What is a CFD?
A contract for difference (CFD) has become one of the most popular forms of ‘derivative trading’. A CFD explained in simple terms if a contract is made between a retail trader and an investment bank, broker or spread betting firm. When the contract is closed, both parties agree to exchange the difference between the opening and closing price of the asset involved in the contract. This means that a CFD can generate a profit or a loss for you, depending on how the price has moved from the opening price of the contract.
The key difference between CFD and invest dynamics is that CFD traders speculate solely on the price movements of an asset, without having to take ownership of the said asset. An investor in an asset will take direct ownership of the asset in question. A CFD contract will not, therefore, correlate directly to an asset’s underlying value. Instead, it will focus on the price differential between the contract’s entry and exit points in the market. Although CFD prices are largely pegged to an asset’s underlying value, it won’t ever be identical given the spread applied by most CFD brokers – their profit margin for taking your speculative contract.
In essence, a retail trader will use a CFD to try and correctly predict the performance of an asset, which will result in a profit. The element of risk remains, and it is possible to incur a loss if the market moves against you.
What is CFD trading and how does it work?
When it comes to the meaning of CFD trading, a retail trader will commit to buying or selling a set number of units of a particular asset within a contract with their broker. For each point the value of an asset moves in your favour, you will profit in multiples of the units you’ve bought (or sold). Unlike other financial instruments, CFDs do not have expiry dates, meaning the contract remains active until you decide to close it. It is worth noting that futures contracts, which may relate to a commodity such as oil, will expire at an agreed date.
If you are new to online CFD trading and you want to know how to trade CFD markets effectively, let’s take a look at a few examples:
- Asset A
Asset A is currently trading at a sell/buy price of 990/1,000p. You want to purchase 10 units in Asset A because you feel the price will rise. The margin rate is 5%, which means you only need to commit 5% of the total cost of the trade upfront to the broker. In this case, that’s £5 of a trade worth £100 (10 units x 1,000p).The price does move the way you expect and moves from 1,000p to 1,030p – a 30-point profit. You decide to close your contract at 1,030p, taking a 30-point gross profit of 30 x £10 = £300, less the commission charged by your CFD trading platform to calculate your net profit.
- Asset B
Asset B is currently trading at a sell/buy price of 490/500p. You decide to buy 50 units in Asset B because you feel the price will rise. Again, the margin rate is 5%, which means you only need to commit 5% of the total cost of the trade upfront to the broker – £12.50 of a trade worth £250 (50 units at 500p).This time, the price moves against you, falling from 500p to 475p – a 25-point loss. You decide to cut your losses and close the contract at 475p – taking a 25-point gross loss of 25 x £5 = £125.
- Asset C
Asset C is currently trading at a sell/buy price of 590/600p. You decide to sell (short) 10 units of Asset C because you believe its price will decline in the short term. The margin rate remains 5%, which means you only need to commit £3 upfront towards the trade. (5% of 10 units x 600p).The price does move the way you anticipate and falls further from 600p to 550p. You decide to close your contract at 550p, taking a 50-point gross profit of 50 x £6 = £300, less the commission charged by your CFD trading platform to calculate your net profit.
If you are wondering are CFDs safe to use, the answer is yes – providing you trade CFDs with a broker that’s regulated by the likes of the UK Financial Conduct Authority (FCA), the Cyprus Securities and Exchange Commission (CySec) and the Australian Securities & Investments Commission (ASIC).
You might also be wondering that if CFDs are safe, why are they illegal in the US? The US Securities and Exchange Commission (SEC) has placed significant restrictions on over-the-counter (OTC) financial instruments – and CFDs fall under the OTC umbrella. At the time of writing, OTC financial instruments are against US securities legislation.
While a regulated broker will ensure trading will be performed in a compliant manner, this is not a guarantee that your trades will be profitable. Your research, along with general market sentiment, will determine if your trade will bring a profit or loss.
Why CFDs have become a popular option amongst investors
There are many reasons why CFD trading has become a credible alternative to investing directly in assets. First and foremost, CFDs offer a low barrier of entry to trading beginners. Margin trading makes it possible for those with modest trading bankrolls to take a position on large-scale assets without being constricted by having to invest in whole shares.
As with our CFD trading example of ‘Asset C’, CFDs make it possible to profit when assets fall in value as well as rise. There are two types of contracts you can open with a CFD broker – a long (buy) order if you think the price will rise, or a short (sell) order if you think the price will fall.
The number of CFDs available to trade continues to rise too, with the opportunity to speculate on a variety of markets and assets to diversify your trading portfolio. This may result in a profit or loss depending on the movement of the market. Furthermore, profits from CFDs do not incur stamp duty because you never own the underlying asset. However, they are liable for capital gains tax in the UK.
Liquidity in CFD transactions is hugely impressive, with contracts executed instantly by your chosen broker – ideal if time is of the essence and you wish to take a short-term position on an asset. You can also increase your exposure to an asset with just a fraction of the invested capital by using leverage. If you are unsure what is leverage in CFD trading explained terms, leverage in CFDs relates to the retail margin offered by a CFD broker. In certain markets, assets can be traded with CFDs at a leverage of up to 1:30 – meaning you only have to risk 3.33% upfront. However, if the price goes against you, you will be liable for the losses charged at the total 30x exposure. Similarly, if the price goes in your favour, you can magnify losses up to the total 30x exposure.
When it comes to CFD trading fees, there are different details to be aware of. You will need to consider the spread, which will be calculated at the point the position is closed. If the position is open for more than a day, overnight and/or weekend fees may be applied, depending on the type of CFD you open. If the position is leveraged, there will also be a LIBOR fee applied, which is the rate for the short-term loan for the leverage. In some instances, depending on how the position moves, an overnight refund may be credited to your account.
CFD traders can also take full control of their positions, with flexible stop loss and take profit orders capable of automating exit points in the market and removing emotion from trades.
Spread betting Vs CFD Vs Options: Differences and Similarities
Three of the most popular leveraged trading products are CFDs, spread betting and options. What is the difference between spread betting and CFD, as well as options?
If you want to know whether to trade using spread betting or CFD brokers, the primary differentiator between CFD and spread betting is their taxation. CFD profits incur capital gains tax, whereas spread betting earnings are exempt from both capital gains and stamp duty taxation.
A CFD differs from an option in terms of the contract’s execution. When you open a CFD, you agree to exchange the difference between the opening and closing price upon execution. With an option trade, you sell or buy the right to trade an asset at a predetermined price. CFD options traders can therefore buy assets for a fixed price during a set period that may be less than its market value.
Trading CFDs with eToro
As a retail trader with eToro, you can trade many types of CFD online across a broad spectrum of financial instruments, including forex, commodities, indices, stocks and cryptocurrencies. Indices like the SPX500 or DJ30 are traded exclusively using the CFD market as they are not physical assets and allow you to speculate on the broader performance of an index e.g. an entire industry or national economy.
eToro is a fully regulated broker with the FCA, CySEC and ASIC, with CFD trading available to clients residing in the UK, Germany, Italy, Spain, France, Australia and many other nations. As with all forms of financial trading, operating a CFD account carries an inherent level of risk. However, we offer plenty of trading features to help manage positions and maximise your CFD trading opportunities.
Additional features for CFDs
As a retail trader with an eToro account, you can benefit from two key functions within the eToro CFD markets. You can sell (short) positions and use leverage.
Sell short positions
Using our intuitive trading interface, it’s just as easy to short sell an asset as it is to go long (buy) it. Simply switch the toggle from ‘BUY’ to ‘SELL’ on your chosen asset, set the amount you wish to sell and execute the order. Once the position is live in the market it will appear in your eToro portfolio as a ‘SELL’ order. CFDs make it possible to turn a profit from an asset even if its value declines. Short selling is also a useful hedge to safeguard other profitable positions linked to the asset in question. This is short selling explained in its simplest form.
If you don’t wish to commit significant funds upfront to a CFD trade, but you want considerable exposure to an asset, take advantage of our CFD margin. Margin in CFD trading is displayed in a multiplier form, explaining how much borrowed capital applies to your trade. If you were to open a CFD on an asset at a cost of £1,000, for every percentage move up or down, you will earn or lose £10. If you were to invest £1,000 on an asset at a 10x leverage in CFD terms, your profits and losses are magnified tenfold. For every percentage move up or down, you will earn or lose £100 instead, despite only having to commit £1,000 to the trade upfront.
Risk management strategies and tips for beginners
- Choose a reliable broker
First and foremost, it’s important to select a reputable CFD broker that you can trust with your money. Any CFD broker worth their salt should be licensed and regulated by a respected financial services jurisdiction. By dealing with regulated CFD brokers you can be sure they must comply with the strict operating standards of the licensing body. The most stringent jurisdictions to look out for include the Financial Conduct Authority (FCA), the Australian Securities & Investments Commission (ASIC), the European Union’s Markets in Financial Instruments Directive (MiFID) and the US Securities and Exchange Commission (SEC). At eToro, we are regulated by both the FCA and ASIC, as well as the Cyprus Securities Exchange Commission (CySEC) for our EU-based clients.A suitable CFD broker should also provide the best CFD trading platform possible, with an intuitive user interface that’s quick to navigate. It should also offer a broad spectrum of assets to trade, allowing you to operate an expansive CFD portfolio.
- Develop CFD trading strategies
One of the biggest cardinal sins beginners make in CFD trading is opening positions without a defined strategy. Create and test CFD trading strategies before you commit too much money into your trading account. Most people who use CFDs are short-term traders or day traders that look to take small percentage gains from an asset’s value rising or falling during the same day. You can develop CFD day trading strategies using fundamental analysis and technical analysis. The former relies on keeping abreast of the latest news and releases surrounding the asset you wish to trade. Positive and negative news can help an asset’s value to rise or fall respectively. Meanwhile, technical CFD analysis requires you to be proficient in using and understanding charts and other CFD trading tools that help you to spot trends regarding the movement of your chosen security.
- Use a virtual trading account to try day trading and swing trading
It doesn’t matter whether you prefer day trading or swing trading CFDs, whichever approach you take you should create a demo trading account with your chosen CFD broker first. At eToro, we offer a free virtual trading account, giving you $100,000 in virtual money to start trading CFDs risk-free within an eToro practice trading account.
- Minimise your use of leverage
Leverage can be considered one of the advantages and disadvantages of CFD trading, especially as a beginner. Although it might be tempting to try and gain greater exposure on a chosen CFD with less capital, keep in mind that leverage can magnify losses just as quickly as profits. As a beginner to trading CFDs, we would highly recommend minimising your use of leverage or CFD trading without leverage as a starting point. This will help to mitigate the potential losses involved should you make mistakes when entering or exiting the market.
- Utilise trailing stops to preserve capital
When starting as a CFD trader, one of the best ways to protect your trading bank and your risk per trade is to work with trailing stop losses. A trailing stop is designed to preserve profits by ensuring a trade stays open – so long as the price continues to move in the right direction. The trailing stop kicks in and closes a trade once the price begins to retract in the opposite direction. A trailing stop eliminates the emotion from a trade and ensures you get good value from profitable trades and avoid incurring losses by chasing higher gains.
- Limit your exposure on each position
Trading bankroll management is key to ensure your account can recover from losing CFD trades. It’s vital to limit your overall liability on individual trading positions. Look to commit no more than 1%-2% of your total trading bank to a single trade – regardless of how good the opportunity may be. By taking this consistent approach, you can start to ascertain your average return from a 1%-2% liability, establishing a risk-reward ratio and the percentage of winning trades you need to be profitable.
- Cease trading if you cannot control your emotions
It’s important to prevent emotions from clouding your judgment in the markets. This is one of the most pertinent CFD trading tips for any beginner. If you have had a losing trade, avoid the temptation to chase your losses and cease trading for the day. The markets will always be there another day and there will always be other opportunities to profit in future.
- Define your risk-reward ratio
Over time, you need to set up your entries into the CFD markets in accordance with how much you are willing to lose per trade. This is known as your risk-reward ratio. For a CFD trading strategy to be profitable, you will need a strike rate that’s aligned with your risk-reward ratio. Avoid high-risk strategies that may pay off regularly, but one bad trade could wipe out your entire profits.
- Follow proven traders with CFDs in their profitable portfolios
If you don’t have time to develop CFD trading strategies for yourself, at eToro you can always copy other profitable traders that open long and short CFDs within their portfolios. You can discover the most popular traders to copy, based on their percentage returns generated in the last 12 months. You can also see how many other users are copying their trades.
In summary, CFD trading is a tax-efficient way to gain exposure to some of the biggest assets in the financial markets. Using margin and leverage, it’s also one of the most cost-effective, providing you manage your risk responsibly and protect your trading bank. Below are three key takeaways to remember when trading CFDs online for the first time.
- Choose a CFD broker you can trust. Make sure they are well-regulated and offer an intuitive CFD trading platform that’s accessible on all devices.
- Limit your use of leverage as a CFD trading beginner. It’s the best way to minimise losses while you’re understanding how the markets work.
Open a demo account with eToro first. Get started with a virtual eToro account and execute CFD trades using virtual money, with no risk to your own money.
This information is for educational purposes only and should not be taken as investment advice, personal recommendation, or an offer of, or solicitation to, buy or sell any financial instruments. This material has been prepared without regard to any particular investment objectives or financial situation and has not been prepared in accordance with the legal and regulatory requirements to promote independent research. Any references to past performance of a financial instrument, index or a packaged investment product are not, and should not be taken as a reliable indicator of future results. eToro makes no representation and assumes no liability as to the accuracy or completeness of the content of this guide. Make sure you understand the risks involved in trading before committing any capital. Never risk more than you are prepared to lose.