What is CFD Trading and How Does it Work?

Beginner

Contracts for difference (CFDs) are a type of Over The Counter (OTC) financial instrument that enables investors to bet on the price fluctuations of various assets such as foreign exchange (forex), equities, and commodities without the necessity of actually owning those assets.

What is CFD Trading?

Initially, Contracts for difference (CFDs) were predominantly employed by hedge funds for trading purposes. By the late 1990s, the landscape for CFDs began to change as they became accessible to retail investors through online trading platforms. This innovation opened the door for trading CFDs on a broad range of assets including indices, stocks, and foreign exchange markets, not only in the UK but eventually extending to other regions like Australia and Europe.

Today, Pepperstone offers CFD trading services across a diverse array of financial markets. These services are provided via a sophisticated and user-friendly online trading platform, designed to make it easier than ever for traders to engage in CFD trading.

A CFD represents an agreement between an investor and a broker, whereby the broker agrees to settle the difference in the price of an asset from the time the trade is opened to when it is closed. Investors have the flexibility to take either ‘buy’ (long) or ‘sell’ (short) positions, depending on their predictions of market movements.

In essence, a CFD is a derivative that permits investors to speculate on price changes in various financial markets without owning the underlying assets. Instead, they gain exposure solely to the asset's price movements.

Pepperstone’s platform offers access to over 1,200 markets, allowing investors to speculate using CFDs on a wide array of assets, including stocks, indices, forex, and commodities.

How Does CFD Trading Work?

CFD trading involves speculating on the price movements of financial assets. This means investors can potentially profit whether the prices rise or fall.

CFDs are contracts that replicate the behavior of financial markets, allowing you to buy and sell them similarly to actual assets. They offer several advantages, such as the ability to take short positions (trading on speculating price declines), leverage (trading with borrowed funds), and hedging against other investments. However, trading CFDs also come with a number of disadvantages, including high leverage risks, overnight financing costs, and potential for overtrading.

Put into context, instead of directly investing in a specific quantity of an asset, such as purchasing 100 shares of Barclays stock, an investor can instead buy (long) or sell (short) a number of CFD contracts to trade. An investor's gains or losses depend on the market's movements relative to their position.

In this scenario, an investor who buys 100 CFDs (Contracts for Difference) of a company at $2.00 per share and sells them at $2.50 per share would net themselves $50 (100 units x $0.50 gain). Conversely, if the price dropped to $1.50 per share, they would lose $50.

Going Long in CFD Trading

A major benefit of trading CFDs is the flexibility to speculate on an asset's price movement in either direction.

Going Short in CFD Trading

Conversely, if an investor believes the value of an asset is going to decrease, they can open a short position by selling the asset. In this scenario, the investor profits if the asset's price drops as anticipated. But if the asset's price unexpectedly rises, they will suffer a loss.

Leverage in CFD Trading

One of the standout features of CFDs is the utilization of leverage. Using leverage in trading enables investors to significantly increase the size of their positions and the associated risk-return potential.

In essence, leverage permits investors to manage a substantial position with a relatively small initial investment by borrowing capital from their broker. For instance, with a leverage ratio of 10:1, an investor can control a $10,000 position with just $1,000 of their own money.

To illustrate, consider a scenario where an investor wants to invest US$1,000 in Brent crude oil, and their broker mandates a 10% margin requirement. In this case, the investor would only need to deposit US$100 to initiate the trade.

While the use of leverage can enhance profitability if the market moves favorably, it also carries significant risks. The same mechanism that amplifies gains will also amplify losses, making leverage a powerful but potentially hazardous tool in trading.

Margin in CFD Trading

The amount of funds an investor needs in their account to initiate and sustain a leveraged position is referred to as their margin. This margin is usually expressed as a percentage of the total trade size and varies across different markets.

There are two primary types of margin investors need to be aware of:

Initial Margin: To open a new position, an investor’s available equity in their account must be greater than the initial margin requirement.
Maintenance Margin: To keep a position open, an investor’s available equity must always be above the maintenance margin level. If it falls below this threshold, a margin call will close their position(s) regardless of profit or loss.

It's vital to note that both potential gains and losses are amplified for investors when utilizing leverage, as they are calculated based on the entire position size, not just the margin.

Understanding CFD Pricing

Pepperstone offers CFD trading and, therefore, aligns prices with those of the underlying asset and then apply a commission on the transaction, with an overnight financing charge for long and short positions depending on the funding rate or swap rate. This ensures that investors trading in normal market sizes or smaller will receive the best available bid and offer prices at the time of trading.

The spread is the difference between the buy and sell price of a CFD and is also known as the 'dealing spread’. A narrower bid-offer spread is more advantageous for investors. The spread size varies depending on factors such as the volatility and liquidity of the financial instrument.

It should be noted that depending on the account type and the instrument traded, Pepperstone may omit the commission and apply a wider spread - investors must ascertain that they are aware of their account specifications and the costs and charges that will be applied on them.

For example, if a CFD is based on Tesla stock, trading at $175.25/$175.75 per share, the quoted bid-offer price might be $175.00/$176.00 after adding the spread. Here, $175.00 is the sell price, and $176.00 is the buy price.

The spread size affects how much the market needs to move in an investor’s favor before they start making a profit. For instance, if an investor purchases 100 Tesla CFDs with a $1 spread, their trade will initially show a $100 loss.

Managing Risk in CFD Trading

Since CFDs are leveraged instruments, it's vital that investors take steps to manage their risks effectively while trading. By utilizing risk management strategies and tools, including Take Profit, Stop Loss, and Trailing Stop investors can manage risk in CFD trading:

Take Profit/Limit Order: Automatically closes an investor’s position once it reaches a predetermined level, which can be a profit target or a more advantageous level than the current position, thereby potentially minimizing losses.
Stop Loss: Conversely, this tool allows an investor to specify a price at which their position will automatically close to lock in profits or limit losses.
Trailing Stop: This order type helps an investor to secure profits by automatically closing their position if the market price moves in an unfavorable direction, based on a set distance from the current price.

Besides these risk management tools, investors can benefit from studying trading charts and learning technical analysis techniques. This knowledge allows them to better understand historical price movements and make more informed trading decisions.

Benefits of CFD Trading

Trading CFDs affords investors with several benefits, including:

Short Selling: CFDs offer the flexibility of short selling, meaning investors can open sell positions just as easily as buy positions, enabling profit from declining prices.
Low Entry Costs: Trading CFDs requires a relatively small initial deposit with which to gain access to trade in various markets, including stocks, forex, and commodities, among others.
No Storage Costs: CFDs, especially those related to commodities, do not incur storage costs as you do not physically own the underlying assets like gold or oil.
Hedging Strategies: CFDs can be employed to hedge risks in both leveraged and non-leveraged portfolios. Hedging involves opening new positions to protect existing investments from market volatility.
Leveraging Capital: CFDs allow investors to use leverage, meaning only a fraction of the trade's full value is needed as a deposit, known as the margin. This can amplify potential profits, but it also increases the risk of larger losses, as gains and losses are calculated on the total value of the position.

Limitations of CFD Trading

While trading CFDs offers many benefits to investors, the financial instrument also has its limitations. Therefore, before engaging in CFD trading, there are several aspects that investors should evaluate, including:

Elevated Risk: CFDs are inherently volatile financial instruments, posing a high level of risk to investors. Investors should, therefore, thoroughly educate themselves about the intricacies of CFD trading or seek guidance from financial professionals before entering the market.
Leverage Dynamics: Leverage in CFD trading can significantly amplify both potential profits and losses. While leveraging can lead to substantial gains if the market moves in favor of the investor’s predictions, it also poses the risk of equally substantial losses. The dual nature of leverage necessitates a cautious and well-informed approach to trading CFDs.

By considering these factors and utilizing available educational resources, investors can better prepare themselves for the challenges and opportunities presented by CFD trading.

CFD Trading Platforms

Pepperstone provides a suite of five robust trading platforms, tailored to fit your specific trading needs, no matter your level of experience. These platforms are accessible at no cost and available across various devices, including mobile, tablet, desktop, and through our web application:

TradingView

With seamless integration through our cTrader-powered system, investors can link their Pepperstone trading account directly to TradingView. This platform offers advanced charting capabilities and a suite of news features to help investors stay informed about significant market developments.

MetaTrader 5

MetaTrader 5, the enhanced successor to MetaTrader 4 by MetaQuotes, offers superior performance and precision. It boasts faster processing speeds, supports position hedging, and provides advanced pending order options. Additionally, it includes a wide array of tools and indicators designed to elevate investors’ trading strategies and keep you ahead in the financial markets.

MetaTrader 4

MetaTrader 4 remains the world's favorite trading platform, known for giving investors a competitive advantage. It delivers live quotes, real-time charts, comprehensive news updates, and in-depth analytics. The platform also includes a variety of order management tools, technical indicators, and expert advisors, making it suitable for investors at any level.

cTrader

cTrader offers an intuitive interface that emulates the trading environment of professional institutions, making it an ideal choice for newcomers. Developed by traders for traders, this platform features customisable presets and detachable charts, ensuring a user-friendly experience. It also supports advanced order execution features. For those interested in automation and custom scripts, cTrader provides the capability to code using C#.

Pepperstone Trading App

Pepperstone’s new trading app gives investors access to global markets at their fingertips, allowing them to execute real-time CFD trades on price movements across FX majors, minors, exotics, indices and commodities.. From low-cost, flexible funding to choosing an account type that suits you, trading with Pepperstone means having the freedom to make the most of every market opportunity.

CFD Trading Regulations

The trustworthiness of a CFD broker/provider is generally derived from their market reputation, duration in the business, and financial stability. While there are numerous reputable CFD brokers available, it is essential to thoroughly research a broker's history and credentials before committing to opening an account.

When selecting a CFD trading platform, one must consider the regulatory frameworks and licenses under which the service providers operate.

Pepperstone is regulated and authorized by several regulatory bodies, including the Financial Conduct Authority (FCA) in the UK, the Australian Securities and Investments Commission (ASIC) in Australia, the Dubai Financial Services Authority (DFSA) in the UAE, the Cyprus Securities And Exchange Commission (CySEC) in Cyprus, the Capital Markets Authority of Kenya (CMA) in Kenya, the Securities Commission of The Bahamas (SCB) in The Bahamas and the Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin) in Germany.

It’s important to note that CFDs are not available for trading in the United States because they are classified as Over-The-Counter (OTC) products, which are banned under US regulations.

Gold CFD Trading example

Imagine an investor notices a significant surge in activity within the gold market, driven by speculators who continue to drive up the price. The investor believes that there is still potential for the price to climb higher. The investor’s broker quotes the Gold spread at $1,800.00 - $1,800.10.

The investor opts to purchase 30 Spot Gold CFDs at the price of $1,800.10. Given that a standard Spot Gold contract is valued at $10, the total value of the investor's position is $300.

Over the next few days, the investor observes an upward trend in the gold price, and the broker's quote updates to $1,825.10 - $1,825.60. The investor then opts to close their position by selling at $1,825.10.

To calculate the profit, we need to consider the price movement and the contract size. The price moved favorably for the investor from $1,800.10 to $1,825.10, representing a movement of $25 per contract.

The investor can calculate their profit as follows: ($1,825.10−$1,800.10) × 30 × 10 = $7,500.

CFD Trading FAQs

What does CFD mean?

This characteristic allows investors to capitalise on both upward and downward market movements through long and short positions, respectively. This flexibility is particularly advantageous as it enables investors to profit from diverse market conditions without needing to physically own the assets they are trading.

How do I use CFDs for hedging?

Hedging is a fundamental risk management practice employed by seasoned investors to safeguard against potential losses. This strategy involves taking measures to protect capital and profits, particularly in times of market uncertainty. By hedging, investors aim to counterbalance adverse movements in one investment with favourable outcomes in another.

One effective method of hedging is through CFDs, which offer the ability to profit from both rising and falling markets. CFDs enable investors to short sell, allowing them to speculate on price declines. This feature makes CFDs a popular choice for offsetting losses in physical portfolios during market downturns.

For instance, if an investor holds $5,000 worth of Tesla shares and anticipates a decrease in their value, they can utilise CFDs to mitigate potential losses. By selling an equivalent amount of Tesla shares via CFDs, the investor can profit if Tesla's share price falls in the market. This gain on the CFD position could potentially counterbalance the loss in the value of their physical share portfolio.

What is the difference between CFD and real stock?

When comparing CFD trading to traditional shares, a fundamental distinction lies in ownership and leverage.

In CFD trading, investors do not acquire actual ownership of the underlying shares. Instead, they speculate on price movements, potentially profiting from favourable market shifts or incurring losses if trends move adversely. Conversely, traditional share trading involves purchasing shares outright, entitling the buyer to legal ownership and any associated benefits, such as dividends and voting rights.

CFDs operate on leverage, necessitating only a fraction of the total trade value as a deposit to initiate a position. This amplifies both potential gains and losses. In contrast, traditional share purchases require full payment upfront, offering ownership of the shares without the leverage component inherent in CFDs. Thus, while CFD trading offers flexibility and speculative opportunities, traditional share trading provides tangible ownership and direct participation in a company's equity.

What markets can I trade on?

Pepperstone offers investors the opportunity to trade 1200+ CFD instruments across FX, indices, equities, energy and commodities, among others.

What is CFD Trading and How Does it Work? | Pepperstone (2024)