Most online brokers offer CFD trading nowadays. This type of financial asset is preferred by many traders due to the simplicity of opening and closing trades. Unlike real asset trading, CFDs on other assets do not imply ownership of the underlying asset, which is why it’s more convenient.
Read on to find out the basics of CFD trading, some of the best CFD brokers in the UK, and how you can use CFDs in your trading strategy.
Online CFD trading: how does it work?
CFDs, or contracts for difference, are financial derivatives available on many assets, including stocks, forex, commodities, and many more. Unlike real assets, if you buy a CFD on a stock or another asset, you do not own the underlying asset (i.e., stock).
This derivative contract simply allows you to profit from the price movement of the underlying asset. In the case of CFDs on stocks, you are still entitled to dividends (if paid by the company), but you are not the stock owner.
Traders use CFDs to open long or short positions. For a long position, you need to buy a CFD and sell it after the price increases to pocket the profit. Alternatively, you can also open short positions – i.e., short-sell an asset and buy it back at a lower price (a strategy used in falling markets).
CFD derivatives often come with specific costs, such as the spread, which is often included in the asset’s price on the trading platform. This is the difference between the buy and sell price and is the broker’s profit on the trade. Some brokers may also charge commissions (usually fixed fees) on CFD trading. Also, keeping CFD positions overnight will come with a cost known as swap or overnight fee, which is variable, just like the spread.
Another characteristic is leverage. When opting for CFD trading, you often have the possibility to use leverage, or borrow funds from the broker, to open a position for a fraction of its cost. For example, 1:2 leverage means you only need half of the transaction amount to open it: i.e., to buy CFDs on a stock worth £1,000, you only need to invest £500, but you will pocket the profit for the entire trade worth £1,000. However, leverage incurs additional costs.
Assets to trade with CFDs: indices, stocks, commodities, and more
CFDs offer a wide variety of underlying assets in markets around the world, ranging from stocks to forex and many more. It’s important to note that CFDs on crypto are not allowed in the UK. If you want to trade or invest in crypto, check out our best crypto brokers article instead.
- CFD on stocks: allows you to invest in stocks, long or short positions. This does not mean that you own the shares of the company, you only speculate on the price movements of the underlying asset.
- CFD on currencies: most brokers offer all major currency pairs. The profit or loss will be determined by the movements of the currency prices.
- CFD on commodities: CFDs on commodities allow you to speculate on the prices of assets such as oil, gold, silver, wheat, etc. It is a complex market in which price changes depend on a wide variety of factors.
- CFD on indices: This type of CFD trading allows you to speculate on the volatility of market indices, which is ideal if you want to trade entire markets or industries.
How CFD trading works
To engage in CFD trading, it is crucial to possess substantial experience and knowledge. These instruments are not suitable for beginners due to their high level of risk, which can potentially result in significant capital losses.
For illustrative purposes, let’s outline a series of steps to understand CFD trading:
- Choose the underlying asset: Select the specific asset you wish to trade, such as stocks, indices, currencies, or commodities.
- Determine position (short or long): Evaluate the market scenario and decide whether to open a short position in a bearish market or go long in a bullish market. Conduct a detailed analysis.
- Implement risk management: Consider using risk-limiting orders such as stop-loss or take-profit orders, which are popular risk management tools in CFD trading. Set a predetermined percentage or amount of acceptable loss and adjust your stop-loss accordingly.
- Determine position size and duration: Analyse the amount of capital you are willing to invest and consider the appropriate contract size. Additionally, consider establishing the duration for which the position will remain open, especially for short-term trades.
- Embrace diversification: Explore diversification opportunities across different underlying assets, sectors, or countries to spread risk and enhance potential returns.
When to open and close the position when trading CFDs
When it comes to opening and closing positions in CFD trading, different strategies can be employed:
- Going long: This involves buying an asset when you anticipate its price will rise in the future. It is typically adopted by traders who believe in the asset’s potential value appreciation.
- Going short: In contrast to going long, opening a short CFD position reflects a pessimistic view of future price movements. Traders who expect a decline in an asset’s value may open short positions, especially when they perceive the asset to be currently overvalued.
- Hedging: CFDs can also be utilised for hedging. If you anticipate a potential price drop, CFDs can be used as a means to provide cover or protection against such downside risk.
Furthermore, it is important to consider the purchase and sale prices when trading CFDs. Often, prices are displayed as:
- Ask (offer price): The price at which you can buy the CFD.
- Bid (purchase price): The price at which you can sell the CFD.
When going long, you would open the trade with the ask price and close it with the bid price. Conversely, when going short, you would open a sell position using the bid price and close it at the ask price.
It is worth noting that these prices may differ from those of the underlying asset due to the concept of the spread. The spread represents the transaction cost and reflects the difference between the bid and ask prices.
Therefore, even if a broker claims not to charge commissions, it is important to verify the spread or additional costs for services beyond the buying and selling transactions.
Another crucial consideration in CFD trading is leverage, which allows investors to participate with a fraction of the total trade value. Leverage enables larger trades and potential magnification of profits, but it also amplifies losses. It is essential to exercise caution when using leverage and understand the associated risks. If utilised, it should be done with careful risk management strategies to mitigate potential losses.
Example of CFD trading: buying shares via CFDs
Example: Buying a share of a listed company in a rising market (going long).
For a broker to make a profit, it needs to sell assets at a higher price than it bought them for. This is essentially the bid-ask spread.
For example, the company XYZ stock has an ask price of £11 and a bid price of £10, so the spread is £1, which is the broker’s profit. So, if you want to buy the stock, you will pay £11 per unit, but if you want to sell it, you’ll only receive £10 per unit.
Keep in mind that commissions and other fees (such as overnight fees) may also affect your trade’s profit.
Difference between forex trading and CFD trading
Many online brokers advertise forex trading, but this is usually conducted via CFDs. For the broker to allow you to engage directly in forex trading, they should offer spot forex trading. Forex options, forex futures, and forex ETFs or funds are also options to gain exposure to this market.
Many day traders use CFDs to trade forex, and many brokers offer forex trading via CFDs, including those discussed below.
- CFDs and forex trading are international financial instruments. You can trade a contract for difference in global commodities, indices, treasury bonds, and stocks, among others. CFDs are cash-settled and no ownership rights are transferred. Both short and long positions can be opened depending on whether the trader maintains a bullish or bearish sentiment on the asset.
- Currency trading is an international market. Currencies are not traded through a centralised exchange (such as stock exchanges). The value of one currency is traded against another currency. Transactions are made in pairs, with one currency used to buy another.
- Forex can be traded for speculation, but the main reason is to help with international trade and investments. The largest portion of trades are conducted by central banks, companies, and institutional investors. Forex trading is also used for hedging purposes.
- The CFD market was originally created for hedging purposes. Existing positions in stocks and commodities can be hedged using CFD contracts. Unlike option contracts, CFD contracts do not expire. Overnight positions must be renewed and the CFD provider can charge variable fees.
- Currencies can also be traded on futures exchanges. Futures contracts are available for all major currencies. Some forex contracts are available in mini and micro units, suitable for retail traders. Options contracts are also available on currency futures contracts. Additionally, investors can also invest in currencies via exchange-traded funds listed on the stock market.
How much money can you make trading CFDs and what are the risks?
Let’s explore some general guidelines for achieving profitability in CFD trading:
- Use a low-cost broker and assets: Choose highly liquid assets such as the euro, gold, or major US indices, large-cap stocks, and others to keep your spreads low.
- Favour short positions: Consider utilising CFDs primarily for short positions.
- Use real assets for medium or long-term positions: If you plan to open medium to long-term positions (weeks, months, years), consider using real assets instead of CFDs. While holding short positions with CFDs is generally not particularly expensive over time, be mindful of costs if you need to cover to go long on CFDs, such as overnight fees.
- Use your CFD broker’s data: Although you may refer to the real price chart of stocks or underlying assets (e.g., from futures platforms), it’s crucial to prioritise the data provided by your CFD broker. Ensure you operate in highly liquid markets (e.g., S&P500 index, DAX, EUR/USD) or use longer time intervals, such as daily or higher, to mitigate the impact of spreads on your trades.
- Exercise caution during high volatility events: If you engage in intraday trading, it is advisable to stay away from news releases and other events that generate high volatility. During these periods, brokers tend to widen spreads and take advantage of market confusion.
- Implement effective money management: Develop a precise plan for managing your invested capital. Sound money management is vital for long-term success in CFD trading. Implement risk management strategies and consistently monitor and adjust your positions.
- Sound trading strategy: make sure you devise a foolproof trading strategy. You can use a demo account with virtual funds to test and refine your strategy before risking real cash.
To gain a deeper understanding of CFDs, let’s have a look at their advantages and disadvantages.
Advantages and disadvantages of trading with CFDs
- You can trade both long and short, so you can make profits in both rising and falling markets.
- Wide choice of underlying assets, ideal for any trading strategy and objectives, including diversification or hedging.
- Leverage can be used to multiply profits. However, keep in mind that your potential losses are virtually unlimited if the market goes against you (unless you choose a broker with negative balance protection).
- Many order types are available for CFDs, so you can craft a sound risk management strategy.
- Allowed leverage and trading conditions (including short-selling) are subject to your broker’s conditions and the markets (i.e., there are firm limits to leverage in the UK).
- Essentially unlimited losses if the market goes against you, or at least your entire balance if your broker is regulated and offers negative balance protection. It’s advisable to use stop-loss orders and other risk management strategies to mitigate these risks and protect your capital.
- The CFD does not perfectly replicate the movement of the underlying asset.
- Some brokers may charge quite high spreads, especially for less liquid assets.
Tips for CFD trading
As we have already discussed, one of the tips often given to new CFD traders is to create a demo account with a broker before trading with real money. In any case, there are several tips and recommendations to refine your strategy:
- Use technical analysis to identify the right entry and exit points.
- Use risk management strategies, such as stop-loss orders, to manage risk.
- Stick to the 1% rule (do not invest more than 1% of your capital in one single trade)
- Don’t put all your eggs in one basket – diversify your portfolio across asset classes, industries, and countries.
- Never risk capital you can’t afford to lose (such as your money for rent or living expenses, always have an emergency fund before starting your trading journey).
Use technical analysis
Always devise your trading strategy before placing the orders. Use a demo account to refine it and test it using real-world data. You should learn how to use multiple technical indicators and always base your decision on multiple tools (as opposed to using only one or two indicators to place orders), as some may give false signals. Check out our beginner’s guide to technical analysis to get started with your trading journey.
Use risk management strategies
The use of stop-loss orders is one of the most useful tips when trading CFDs. Stop-loss orders allow you to limit your losses. You simply set a price level when your trade will be closed automatically.
For example, you open a long position and expect the price to increase (so you make a profit). However, unexpected events lead the price in the opposite direction – causing you to suffer a loss. A stop-loss order allows you to set a price level when the trade is closed automatically.
However, keep in mind that stop-loss orders are not guaranteed. If the market is too volatile (i.e., the price drops too quickly), your trade may not be closed, hence you will keep incurring higher losses. Some brokers offer guaranteed stop-loss orders for this reason, usually at a cost.
It is always recommended to stick to the 1% rule – never invest more than 1% of your total capital in one single trade. In this case, even if you make a loss, it is likely to be offset by gains in other positions (especially if you use diversification in your strategy).
Don’t put all your eggs in one basket
You should take advantage of the plethora of assets you can trade via CFDs. Diversification means that, even if you make losses on certain assets, these are quite likely to be offset by gains in other assets. For example, assume you trade both stocks and bonds. When the stock market is falling, the bond market is rising, and vice-versa, so you have a lower chance to make a loss at the end of the day.
Never risk capital you can’t afford to lose
There is no strategy for guaranteed gains. It’s always recommended to start with capital you can afford to lose and you should have an emergency fund, ideally that could cover 6 months of your living expenses before starting trading.
For other tips for managing your risk and money, check money management strategies.
Brokers and platforms for trading with CFDs
Before selecting a broker for CFD trading, it is crucial to thoroughly examine their features to ensure they align with your specific needs. Here are some key considerations:
- Regulation: Verify that the broker is subject to strict regulation by reputable organisations such as FCA. Regulatory oversight provides essential protections for traders.
- Commissions and fees: Understand the broker’s cost structure, including spreads, swaps, commissions, and non-trading fees (such as deposit or withdrawal fees). Refer to the broker’s website for comprehensive information and reach out to them directly for any clarifications before opening a CFD trading account.
- Type of Broker: Differentiate between brokers’ types – such as market makers or STP/ECN brokers.
- Leverage: Familiarise yourself with the type of financial leverage offered, which is subject to regulations.
- Available underlying assets: Ensure the broker offers the specific underlying assets of interest to you, such as stocks, indices, commodities, or currencies. This enables you to implement your trading strategy using only one service provider and achieve greater diversification.
- Research and review: When comparing CFD platforms, consider factors such as the types of brokers available, offered trading accounts, available trading tools, commissions and spreads, regulatory compliance, available trading platforms (e.g., Metatrader, Prorealtime, cTrader), deposit and withdrawal methods, and the quality and quantity of educational materials provided by the broker.
By carefully assessing these factors, traders can make informed decisions and select a CFD broker that best suits their trading requirements and preferences.
Best brokers for CFD trading
Eightcap is one of the leading CFD brokers thanks to its asset diversity and choice of trading platforms. The broker is compatible with the most powerful CFD trading platforms in the world: MetaTrader 4, MetaTrader 5, and TradingView.
The broker is based in Australia and is regulated by top-tier authorities, such as the ASIC and the FCA. You can trade forex, stocks, indices, and commodities, among others, so this broker is ideal if you plan on implementing a multi-asset trading strategy while enjoying a low-cost structure.
Read our Eightcap review for more information.
XTB Group is a well-established brokerage company based in Poland, operating since 2004. They offer a wide range of CFD instruments, including forex, indices, stocks, ETFs, and commodities. Notably, XTB Group provides commission-free trading on ETFs and real stocks from major stock exchanges such as New York, London, Spain, Germany, and Italy. With their innovative X Station platform and a reputation for professional customer service, XTB Group has gained popularity and global recognition.
Read our XTB review for more information.
ActivTrades is a global forex broker founded in 2001, regulated by respected authorities like the Financial Conduct Authority (FCA) in the UK and the Commission de Surveillance du Secteur Financier (CSSF) in Luxembourg. Known for their low trading costs, ActivTrades offers a streamlined account opening process and provides free deposits and withdrawals.
Read our ActivTrades review for more information.
Pepperstone, founded in 2010 and based in Australia, has emerged as a leading forex and CFD broker globally. Regulated by ASIC, Pepperstone has experienced rapid growth and is highly regarded by experienced investors and industry professionals. They offer a comprehensive range of trading instruments and services to cater to the needs of traders.
Read our Pepperstone review for more information.
For more CFD brokers, have a look at our best brokers to trade CFDs article.
Learn more about derivative trading
- Options trading
- Futures trading
- Investing in commodities
- Index fund guide
- Dividend investing
- Investing in stock market
- Stock market for beginners
CFD trading: summary
In conclusion, CFD trading offers a flexible and accessible avenue for engaging in various financial markets. With the ability to speculate on price movements of underlying assets without owning them, traders can take advantage of both rising and falling markets.
However, it’s important to approach CFD trading with caution and proper risk management strategies due to the inherent risks involved, including the potential for significant losses. By selecting a reputable and regulated broker, understanding the costs involved, utilising effective trading strategies, and staying informed about market developments, traders can enhance their chances of success in the dynamic world of CFD trading.
Remember to continually educate yourself, practice with demo accounts, and adapt your approach to changing market conditions. Also, make sure you familiarise yourself with technical analysis tools, such as Bollinger Bands, Fibonacci, Dow’s Theory, or MACD.
CFD trading FAQs
What are the main risks associated with CFD trading?
The primary risks include market volatility, leverage, and overnight financing costs. Market volatility can lead to rapid price fluctuations, potentially resulting in significant gains or losses. Leverage allows traders to control larger positions with a smaller initial investment, but it also magnifies potential losses. Overnight financing costs may apply if positions are held overnight, impacting profitability.
How to mitigate risks when trading CFDs?
You should craft a sound risk management strategy to mitigate risks when trading CFDs. This should include stop-loss orders to mitigate risks related to market volatility, using leverage sensibly, and adjusting your positions accordingly to count for all additional costs, such as overnight fees.
How does CFD trading differ from traditional trading?
Firstly, with CFDs, traders do not own the underlying assets but instead speculate on price movements. This eliminates the need for physical ownership, simplifies the trading process, and offers the ability to profit from both rising and falling markets.
Additionally, CFD trading often involves leverage, allowing traders to control larger positions with a smaller upfront capital requirement.
Another difference is the ability to trade a wide range of financial instruments, including stocks, indices, commodities, and currencies, all within a single trading account.
Lastly, CFDs offer the flexibility of trading various contract sizes and the ability to go long or short on positions.