What is CFD Trading and
How Does it Work?

Learn how to go long or short on thousands of global financial markets with CFDs in this comprehensive guide. Starting at the very beginning – what CFD trading is, and how it works.

CFD trading enables you to hunt for live opportunities across shares, forex, indices and commodities. In this step-by-step guide, we’re going to cover all the fundamentals of CFDs, 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 more than 4500 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 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 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 100 HSBC CFDs at 400p then sell them at 450p, you will make (100 x 50) £5000. If you sold them at 350p instead, you would lose £5000.

CFD example – going long

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 5325.

The market rises 30 points to 5355. 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 (5325) to now (5355).

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 5295, you would lose $150.

CFD Trading Work

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 S&P 500 is at 3340, but you believe that it is about to fall as you expect the forthcoming US earnings season to disappoint.

So, you sell five S&P 500 CFDs at 3340.

Your prediction is correct, and the US 500 falls to 3275. 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 S&P 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.

CFD Trading

Buy and sell prices

You’ll see two prices listed for every CFD market: the buy (or offer) 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.

There is one significant exception to that rule, though. 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 – which is usually the equivalent of 100,000 units of the base currency

What is leverage in CFD trading?

CFD trading is a leveraged product, which means you can open a trade by paying 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 5325 would give you a total position size of $26,625 (5 x 5325). Because CFD trading is leveraged, you would only have to put up a fraction of that, known as your margin.

If oil requires 20% margin, then you’d only need to pay 20% of $26,625 to open your trade: $5325.

Find out more about leverage.

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, including:

  • Flexibility
    You can trade on falling markets as well as rising ones, without borrowing any stock
  • Leverage
    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.

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 OCBC Bank 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 OCBC Bank CFDs.

Should OCBC Bank’s share price 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 4500 CFD markets, including:

  • The world’s leading indices such as AU 200, Wall St and FTSE 100
  • FX such as AUD/USD, GBP/EUR, JPY/USD and 80+ currency pairs
  • Global shares such as DBS Bank, Apple and Noble Group
  • Commodities such as oil, coffee and sugar
  • Metals such as gold, silver and platinum

Is CFD trading right for me?

CFD trading is ideal for investors who want the opportunity to try and make a better return for their money.

However, it contains significant risks and is not suitable for everyone. We strongly suggest trying out a demo account before you get started with your own capital.

CFD trading may be ideal for people:

  • Looking for short-term opportunities
    CFDs are typically held open for a few days or 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 portfolio
    City Index offers over 4500 global markets to trade on including shares, commodities, FX and indices

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, or trade our innovative Knockout Options product – which you can find out more about here.

Learn more about CFD trading risks.

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?

You can choose whether you want to trade a CFD that expires or not. Daily CFDs don’t have expiry dates, while forward CFDs will expire on a set date in the future.

Daily CFDs are mostly intended for shorter-term positions, as they will incur overnight financing 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 opportunities from a single login

Should I use CFD or invest?

It’s up to you. 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 more risky.

Many investors keep their share portfolios while also trading CFDs.

Can you buy and sell the same stock repeatedly?

Yes – there are no limits to how many times you can buy and sell the same stock with a CFD. Some scalpers will even open and close positions on the same market multiple times within a single trading day.

Find out more

Next chapter CFD trading example

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