As you probably know, at the moment there are 4 main types of global markets (stock, commodity, currency and cryptocurrency exchanges). Not so long ago, trading in financial markets required you to have a separate account on each of the exchanges. Traditional trading in shares of foreign companies was completely impossible due to legislation.
However, after the English brokers came up with a Contract for Difference, anyone could trade anything anywhere while having only one CFD trading account with one of the brokers.
This is because CFDs are not the asset itself, but rather just a deal for the price difference. With this contract, you only can get the difference in price from the moment the contract is signed to the moment it is closed, and you do not own the asset itself.
This makes CFD contracts much more convenient, cheaper, and simpler than traditional trading in standard futures or options.
The article covers the following subjects:
What are CFDs (Contracts for Difference)?
Let’s define CFD. Here is a CFD definition:
CFDs are complex instruments that are a type of transaction between two parties regarding the value of an underlying instrument in the future, in which both parties undertake to settle an amount equal to the difference between the opening and closing trades’ prices.
So what is a CFD? Let me try to explain CFD meaning in more detail. CFD is a“contract for difference”, and it is a contract or transaction between a seller and a buyer with the aim of making a profit from the future difference between the closing trade and opening trade prices.
If the closing trade price is higher than the opening price, the seller pays the difference to the buyer, and if the closing price is lower than the opening price, the buyer pays the difference to the seller.
And of course, since a CFD contract is a derivative financial instrument, in addition to the difference itself, it also regulates the time during which this difference is determined.
Initially, the main task of the contract for difference was to make stock trading available. And since stock CFDs are the most popular ones, we will look at what is a CFD position in trading as an example.
Let’s say you want to buy 100 Boeing Company stock contracts. The cost of one stock is $160. In order to buy the stocks themselves, you will need $16,000.
But when buying stock CFD contracts, you do not need to have the entire amount on your CFD trading account, you only need the margin. The LiteFinance CFD broker has a 2% margin on stocks.
So to buy 100 lots of #BA (Boeing Company) stock CFDs, you need only 2% of 16,000, which is only $320 + a small exchange commission, which we will not take into account yet. Several days passed, and the stock price rose to $170 per stock. The price has increased, which means the seller must pay us the difference, which will be equal to 170 – 160 = 10 dollars. Now we multiply 10 by the number of contracts (100) and get 1,000 dollars.
That’s it. Hope from now you could clearly understand what does Contract for Difference mean.
Now let’s see what we would get by purchasing the stocks themselves, and not a contract for difference.
Imagine we bought 100 stocks for $16,000, the price rose to 170 and the value of our stocks increased to 17,000. 17,000 – 16,000 = 1,000. So we got the same 1,000 profit, but in the case of stocks, we would need $16,000 on the account.
In the case of CFD products, we only needed $320. And if there’s no difference – why pay more? This is basically the main advantage of CFD trading over trading the underlying asset itself.
To summarize, it becomes clear that with contracts for difference, we can make transactions that were previously unavailable to us on any exchange. We do not need to have a lot in our CFD trading account to make huge profits.
In my example, we got 1,000 dollars of profit by investing only 320 dollars, and this is more than 300% of the return on investment, which is almost impossible when working with the asset itself.
What is CFD Trading
In order to understand what the CFD underlying market stands for, why it is so popular in the world and how to become CFD traders, let’s take a look at its history.
The first contracts appeared in the mid-90s of the last century in London. In those days, the Forex global markets were still very young and were a currency exchange in the most direct sense: only currencies were traded on it.
The main trading power was concentrated on the Stock Exchange, where real assets (stocks and bonds) and derivatives were competing for the clients.
Since the stock market was one of the main financial markets and there were no alternatives for experienced traders of that time, the government regulated and tightened the screws as it pleased. The exchange legislation changed almost every year, and the main restrictions were associated with the use of the leverage.
Of course, now we are all accustomed to using leveraged trading and change it as we please, from 1:1 to 1:1000. Back then even 1:5 leverage was available only to a narrow circle of financial tycoons.
The second major tax was Stamp Duty. This tax charged large commissions on the purchase of real estate, land, as well as stocks, bonds and other investment instruments.
These two reasons have become the main driving force for young financiers in their search for solutions to avoid these restrictions.
And so the young derivatives company Smith New Court found a solution. “Why buy shares, register them, pay large commissions and taxes if we are not interested in the company itself, but only in changes in the buy and sell prices of its stocks?”
And the financial services company decided to offer its clients to trade not the stocks themselves, but to buy and sell a contract for the difference in the current market price of this stock. And since the issuer of these contracts was the financial services company itself, it had the right to sell them with any leverage its client wanted.
At first, only hunters for short-term deals were interested in the new instruments, but later large investors also seriously considered trading CFDs with stocks. It allowed them to avoid paying a large tax, since there was no actual ownership of the underlying asset.
In the late 90s, a boom in tech companies began and contracts for difference changed significantly. Gerard and Intercommodities became the first financial services company to offer its clients stocks CFD trading via the Internet on the special GNI Touch platform. This is how the first prototype of the modern Forex market appeared.
Over time, online CFD stocks trading began to be offered by other financial companies and CFD providers around the world.
In fact, contract for difference brokers of that time created their own underlying market that was much more accessible for simple private CFD traders, and you didn’t have to be a professional in order to work on it.
The CFD volatile markets allowed anyone to make money on the price difference without owning a real asset. It’s also a time saver because you don’t have to wait until your request for the purchase of a security goes through all the stages from the CFD broker and the exchange to the clearing house and the depository.
A CFD is a derivative financial instrument, which means that it is always based on some underlying asset.
The first CFD assets were based on stocks, and now there is contracts for difference trading for almost everything that can be sold.
Recently, a CFD deal for the outside temperature was registered in the United States. Two people registered their bet in this unusual way, and the loser had to pay the winner the difference in air temperature from the moment the contract was concluded.
CFD trading has a lot of advantages over traditional trading. They include practically unlimited leverage, instant transactions, and low CFD margin. And finally, you can trade CFDs with short positions, while non-margin stocks cannot be short, you can only buy. However, don’t forget that leveraged trading includes high risks and can make your investor accounts lose money when trading CFDs.
How Do CFD Works with Examples
Now let’s figure out how to trade CFDs. It’s best that we use a real example.
For example, we decided to purchase a Tesla stock (#TSLA) CFD. In my opinion, now is a rather convenient moment to purchase contracts for stocks of this particular company. They recently had a significant decline, and according to one of the main strategies, which I will discuss in more detail below, it is rational to buy now.
Before you buy or sell anything, you need to weigh the pros and cons. Pros include, of course, the expected profit, and cons are possible high risk and the size of commissions and spread.
Everything is pretty clear with the profit, so let’s discuss the high risk of losing money in more detail. The fastest way to calculate these parameters is the trader’s calculator. You can use it right here:
The first step is to enter the parameters of your trading CFD account: account type, account currency and account leverage. I have entered the parameters of my trading CFD account;
Now let’s move on to the settings of our future trade. Select the type of trading instrument, in this case it is “NASDAQ contract for difference”;
Next, select the underlying asset. As we have already decided this is Tesla stock, the ticker is #TSLA;
Next, enter the estimated trade volume, or how many CFDs we want to buy. Here you need to know how many contracts there are in one lot. For CFDs on stocks, this is almost always 1 CDF = 1 lot. I decided to buy 100 lots;
Set the type of trade. In our case, this is buy or “long”;
Now we set the price at which we want to buy. Since I intend to buy at the current market price, it is filled automatically;
And now we set the price we expect to see. I expect possible growth around $460 per stock;
After entering the parameters, we press “calculate”, and below appear all the parameters of our future trade;
First, let’s pay attention to the price of one point. At our volume, it will cost us $1;
Next, you can see the margin. This is the amount of money that will be required in our CFD account to buy 100 contracts. As I said above, we do not need the entire value of the stocks, but only a 3% part of the total amount, which is calculated as follows:
Next is the spread that we will pay when opening a trade for our volume. As you probably know, spread is the difference between the buy and sell prices, and it looks like this:
Next comes swap, the overnight commission;
And finally, the calculator gives our estimated profit from the trade with the entered parameters.
There is yet another type of fee – the commission.
As you already know, most brokers on the CFD trading market have 2 types of retail investor accounts, Classic and ECN. Of course, there are also free demo accounts, where you can practice CFD trading, but that’s a completely different story. In short, the main difference between these retail investor accounts is precisely the types and amounts of fees, such as spreads, swaps, and commissions.
On Classic accounts, the spread is higher than on ECN retail investor accounts as it consists of two components – the exchange spread and the brokerage spread.
The market is a free trade zone and everyone wants to make money, both the exchange and the CFD provider. ECN accounts use the so-called “raw” market spread without the broker’s markup, which is much more attractive for CFD traders who work on short time intervals.
But since this is not beneficial for the broker, they charge a commission on these retail investor accounts, which is always a fixed amount. This commission is different for different types of instruments. For example, to trade CFDs with stocks it is 25 cents per lot.
And now a lifehack:
The screenshot above shows how I sold 2 different contracts for difference, one for Google stock and the other for General Electric.
Notice how different the stock sell prices of these companies are. But the most remarkable thing is that the commission in both cases is 25 cents. However, for Google stock, this commission is only 0.017% of the stock price, which is very very low. But for General Electric, this commission is 4.09%.
So we see that it is much more profitable to trade more expensive stocks under such conditions. In fairness, it should be noted that ECN retail investor accounts were created mainly for CFD trading.
Before opening the trade, let’s recall how the profit is generated when working with contracts for difference.
In CFD trading we profit from the difference between the opening price and the closing trades’ positions.
First, let’s look at what happens when you buy a CFD.
The screenshot above shows a trade to buy a NASDAQ CFD.
Since the buy and sell price of the underlying asset and the buy and sell price of the contract for difference are the same, the profit and loss will be calculated in the usual way. Anything above the buy price will make a profit, and anything below it will make a loss. You can close a CFD at any time.
When you choose short selling CFDs, it’s basically the same, only now you profit when the sell or buy price of the underlying asset is below the sell or buy price at which the trade was opened.
Another important issue is the duration of CFD trade, and here I would compare it with its closest neighbor derivatives — futures and options.
As you probably know, one of the main parameters affecting profit when working with derivatives is the duration of the trade.
In the picture above, I compared a CFD with a futures contract and an option over a one-year interval.
As you can see, you will need to conclude both futures and options every quarter in order not to lose in value. You can buy futures for a year, but the buy price will be much higher than the current market price.
It’s the same with the option. But contracts for difference is an indefinite instrument since the underlying asset has no maturity. You can keep your trade open for as long as you like.
Let’s now look at the trade.
For clarity, I made the trade on two different ECN and Classic retail investor accounts at the same time in order to help you understand the tangible difference between the trading conditions.
Trading conditions can be viewed in the “information about instrument” tab.
- The first and most important difference is the spread or difference between the buy and sell price. ECN accounts use raw market spread without a broker’s markup, and this is clearly seen in the screenshot above: the spread on an ECN account is 75 points, while on a Classic it is 94 points.
- The second difference is the amount of leverage built into the instrument, which we will talk about later. On an ECN account, the leverage is 1:50, and on a Classic account, it is 1:33.
- The third difference is the margin percentage, which determines the required margin for trading a CFD. On ECN accounts, it’s 2% of the total value of the underlying asset, and on Classic accounts, the margin is 3%, which requires a larger amount on the trading account.
Now let’s trade.
I will open CFD trades on two different accounts.
- First we choose the type of trade: we have already decided to buy.
- The next step is to set the required volume in lots. 1 lot is equal to one stock for these stocks. We are buying 100 lots. Click “buy”.
- After the trade is opened, compare the parameters between the accounts. To do this, click on the status bar of the trade. Here you can see the first difference – margin. As I said above, the margin trading percentage on the accounts is different, and this difference of 1% cost us more than $400 in margin. On the ECN account it is less and amounts to 845.18 USD, and on the Classic account the margin amount is 1,271.19 USD.
- To open the parameters window, you need to click on the three dots to the right of the “close” button. Don’t miss or you’ll close your position by accident.
- Another important difference between the accounts is the commission. As I said above, it is 25 cents per stock. We have bought 100 shares (contracts), which means that the commission will be 100 times higher, namely 25.00 USD. There is no commission on the Classic account, and we saved $25, but it’s not so simple. If you remember, the Classic account has a larger spread, which usually compensates for this commission.
- As a result, our current profit will add up to the difference in quotes and commissions. The profit formula will look like this:
In other words, I bought 100 contracts of Tesla stock. The buy price of one point is $1. If I bought at 400 and closed at 410, my profit would be: 100 * 1 * (410-400) = 1,000 dollars.
After some time, I closed my CFD trades, and the profit on both accounts was roughly the same.
As I said, the high spread on Classic was compensated by the commission on ECN, and the only difference was in the margin, which was lower on ECN.
As I have said several times, the scope of contracts for difference is very broad.
At the moment, there are 4 main types of exchanges (stock, commodity, currency and cryptocurrency). CFD trading exist for almost all types of instruments on these exchanges.
The most popular way to trade CFDs is still with stocks for the most popular companies, the so-called “blue chips”.
Why? Let’s recall how contracts for difference were created.
First of all, they are for investors who cannot not buy shares of foreign companies by virtue of the law.
In second place are contracts for commodities such as oil, gold, coffee, tea, gas and many others.
The third most popular choice are contracts for stock indices.
Lower in this list are CFDs for currencies and cryptocurrencies.
I have compiled a table of the most popular contracts for difference by type of exchange.
By the way, my CFD provider LiteFinance has all the instruments in this entire list. It’s one of the first Forex brokers to offer CFD Forex trading services.
How to start Trading CFDs
Now let’s find out how to trade CFDs. However, before entering this underlying market, it’s crucial to be aware that CFD trading involves risk and may lead you to losing money rapidly unless you have a clear understanding of this financial instrument.
The first step is to draw up a strategy. It can be hypothetical or quite real in the form of step-by-step instructions. For those who are just taking their first steps in the financial markets, I recommend drawing up a plan on paper.
Are you ready? Then let’s start:
1. First of all, you need to register an account with one of the Forex brokers.
Why Forex? Because Forex brokers have the most extensive range of contracts for difference, which is much wider than that offered by stock brokers and investment banks.
I worked on my instructions for you in my LiteFinance personal account, which I’ve had for many years.
Why did I choose to trade CFDs with this provider? Because I’ve been satisfied with it for many years.
However, I do not recommend starting trading with real money right away. In order to get started on this market and not let your investor accounts lose money when trading CFDs, it would be best to start with virtual money, i.e. create a free demo account.
2. After you’ve created the free demo account, you are in your personal account. On the left is the main vertical panel, where you select the first item of the menu “Trade” and click on it.
3. The trading page will open, and at the bottom of the screen you can see a gray highlighted horizontal bar in which zeroes (0.00 USD) appear in four columns. This is the trading terminal panel, where you can find a record of the funds in your trading account. Now it is empty because our demo account is empty.
4. First you need to deposit to your account. To do this, click on the blue “Deposit” button.
5. Then a window will appear in the middle of the page, consisting of two parts. First, we are offered to open a real account. In the second there are two fields; enter the required deposit amount in the upper one. 10,000 virtual dollars is enough for a start.
6. Now press the “Continue” button.
7. After a few seconds, your balance is not 0.00, but 10,000 USD.
8. It’s time to start testing. To do this, click on the “Trade” tab on the main panel.
9. A menu will appear at the top, where all traditional trading instruments are classified by groups. Since we are going to open a CFD trade, we are primarily interested in stocks, which means that we will select the “Stocks” tab in the panel.
10. A list will open with all the stocks for which the broker provides a contracts for difference. Earlier in the article, we mentioned Tesla stock CFDs. Since we know them a little better than others, let’s practice CFD trading on them. Click on the name of the stock or on the logo.
11. After clicking, a window for trading these stocks will open. In the center of the screen there will be a stock price chart. If you are already familiar with the basics of technical analysis, you can apply it.
12. After analyzing the price behavior, I decided that I would play long. So we switch to the “buy” tab on the right in the trade type field.
13. In the line below you need to enter the desired buy volume. The minimum volume is 1 lot or one stock. But since we have 10,000 USD, it makes no sense to buy one share. I decided to buy 100 stocks, or 100 Tesla CFDs.
14. After checking all the data, we only need to click “Buy”, and our request will go to the broker and the CFD trade will be opened.
15. After just a few minutes, I saw the result of my actions. The values in the lower field of the terminal began to change and the price really went up, bringing me a profit of $173. For clarity, profit is displayed in green and loss in red.
16. Our balance has also changed in the terminal field. Now it’s not 10,000, but 10,148.
Now a question. Why is my profit $173, while net income on our account is $148? The answer is simple – commission. The broker took the commission when the trade was opened, and it is automatically deducted from the profit. As you remember, it’s 25 cents per contract, or in our case, 25 dollars, since we have 100 contracts. 173 – 25 = 148.
17. A profit of $173 is quite enough for a start, so we can close our trade.
To do this, click on the field where the balance is changing and a tab will open a little higher with our trade or trades. We find the right one and there will be a “Close” button on the right. Click it and our trade is closed.
18. Profit on a demo account is certainly good, except we don’t have a tangible result apart from the joy of achievement.
If you seriously decide to learn how to trade CFDs with profit, you need to start making real money, and you need a live account for this.
First, let’s switch our personal account to live CFD trading. To do this, click on your profile icon in the upper right corner of your personal account.
19. A small settings tab will open, where you need to click on the “Enable Live Trading” button.
20. After clicking on this button, the status of your personal account changes to “Live Account”. We are doing a serious trading journey now.
21. First of all, we need to deposit money to the live account. To do so, select the “Finance” tab in the main panel.
22. In the window that opens, in the top menu, select the item “Deposit”.
23. A window will open with deposit options, from a bank card to electronic payment systems. You can choose whichever method is more convenient for you.
24. After choosing the deposit method, you need to place a deposit request.
The first field will be the deposit amount.
Everyone’s situation is different, but I will give you one tip. I have been working in various financial markets for more than 10 years and came to the conclusion that the deposit amount only depends on the goals that you set.
All the goals can be divided into 3 types: trying, playing, and earning. And “playing” is by no means a joke. After we switched to live trading mode, the jokes ended. Because our own money is at stake and we don’t want to just give it away.
If you are in this category, in order to trade CFDs, to understand how it all works and try to earn your first capital. An amount twice the price of the chosen stock will be enough.
Why twice the price? So that one or several unsuccessful CFD trades do not damage your deposit too much. In the case of our Tesla stocks, where one stock is worth about $400, $1,000 is enough.
Playing. This option is suitable for those who are interested in the financial markets but have no desire to get into all the intricacies of trading power, learn and calculate. They just want to buy a certain stock for a certain amount of money and earn 100, 200, 300 or even more percent of profit.
Do you think this is unrealistic? It’s not, but such trades are 99% luck, and that is why this category is called “playing”. However, I know a lot of examples of quite successful playing.
For example, let’s go back 2 weeks and sell CFDs for the familiar Tesla company, which then cost $ 2,200 per stock. A little over 100 contracts could be sold for $1,000, and in just one day they brought $180,000.
This is a very real story, only there were few lucky players since the probability of such a fall was almost zero. So if you are into this kind of trading style, deposit 1,000, 2,000, 3,000 or however much you want, bet all the money on some unlikely event and wait.
If it happens, you will get rich in one day, but if it doesn’t work, at least you tried.
Someone will be able to work out their own profitable strategy and start earning steadily with the help of the knowledge gained along the way.
Someone will apply this knowledge and experience to work in a field related to financial markets.
Someone will gain invaluable experience and decide to go along the path of creating a brokerage company.
And someone will choose the path that I have chosen. In addition to quite successful trading journey in the market itself, I found myself in education and financial analysis.
If you want to follow the path of becoming a real trader and learn how to make money, you need strong start-up capital and some calculation skills.
My first serious capital was about $4,000. I have already written many articles where I talk in great detail about trading costs. So if you need more information, find my other articles.
Let’s continue. Today I have chosen 4,000 as our start-up capital because the stock trading costs $400.
25. After depositing, click on the “Trade” button and see the required amount appear on your account. It will be displayed in the “Total Funds” field.
26. I have 4,852 instead of 4,000 because I already had a balance of 852 dollars from my early activities.
27. Let’s start our serious trading.
Let’s click on the “Stocks” tab and slow down a bit. Since we have real money, rash actions are not for us. First of all, we need to draw up a so-called trading plan.
You can find a bunch of articles about trading plans both on the Internet and on this blog. But since I mentioned it, I will draw up a short trading plan for you too.
A trading plan is a set of rules that you absolutely must follow in order to achieve a positive result. And it basically looks like this:
My trading plan, which I use now, has 37 points, and I know all of them by heart. The process of evaluating a potential asset can take me from a few seconds to a week.
For someone who sees a trading plan for the first time it will take about an hour to work through a single point. But without a trading plan your CFD trades will be random, and we can’t talk about a stable profit. I will not go into detail on each point of the trading plan, as I am going to devote a separate article to this. Let’s get by with the basic sections.
In order to make an informed decision to open a long or short position, we at least need to decide on the working time when the instrument is being traded, choose the trading instrument, usually after technical or fundamental analysis, and distribute a part of the capital for the trade.
28. After you have coordinated your desires with the trading plan, you can finally start trading. Click on the selected instrument. In our case, this is again our favorite Tesla.
29. If we stick to technical analysis, we should pay attention to the price chart.
There are a huge variety of trading strategies, but one works almost flawlessly – the market gap. I will not go into details, because I’ve described this strategy in detail in one of my articles.
The general idea is that trading has just begun and a price gap has formed, which is likely to lead to a short-term rise in the stock price during the next hour or two. Time is running out and you need to act.
30. Since the market rises in price, it means that we will buy. We set the trade type as “buy”.
31. Then we set the volume of the trade. I’ve already calculated that 100 contracts will cost me about $900 in CFD margin. This is quite acceptable for my balance of almost 5000, so I will buy 100 contracts.
32. After setting the parameters, I click “buy”.
33. And now a side note for those who are not great at financial analysis and trading strategies. There is a section “Analytics” for you; the button is located on the main panel of your personal account.
34. In the window that opens, click on the “Analytics Feed” and find the required instrument in the feed.
35. There’s today’s Tesla review there. When you click on it, you will see a brief analytical review of one of the company’s analysts with their opinion on this instrument. You can use the author’s arguments and do what they recommend. But for the future I will say that it is always better to rely on your own opinion.
36. While we were hanging out in the “Analytics” tab, changes occurred in the price chart. The price started to rise, as we expected.
37. And now it’s time to take a look at the trading panel to assess the state of our deposit. During those 10-15 minutes that we studied analytics, prices rose and at the moment our trade is bringing us a profit of $560.
38. I believe that this is more than enough for a 10-minute trade. Our strategy has worked and we should hurry to close our trade and take the profit. You already know how to do this, click on the “Close” button.
39. After the trade is closed, I suggest enjoying the first profit properly. In other words, you need to withdraw the profit and feel it in your hands.
40. This is a very useful exercise for novice and experienced traders, which is great for building self-confidence. To withdraw profit from a CFD trading account go to the “Finance” section.
41. Only now, instead of the “Deposit” tab, click on the “Withdrawal” tab.
42. Again, select the withdrawal method.
Your CFD trading account will appear in the field with the balance and amount available for withdrawal. I have 5,479. If you remember, I deposited 4,000, plus there were about 900 dollars on the account. In total, I decided to withdraw the surplus over 5,000. 479 dollars is quite enough to go and buy myself a gift for diligence and a well-thought-out strategy.
CFD Trading Examples
After we have analyzed how CFD trading works and explored CFD position examples, let’s summarize and recall the basic principles when working with a contracts for difference.
The first thing to recall is how CFDs work, how profit and loss are determined.
After we have made the decision to start trading, we must turn to our trading plan.
After deciding on a trading instrument and parameters, we make a decision to buy or sell. The trading result will directly depend on whether we choose the direction correctly.
Determining the expected result is easy. Above I have already given the full calculation formula, but there is also a simplified formula. You just need to multiply the difference between the closing and opening prices by the price of one point at the volume of your choice.
In the picture above, I decided to move away from stocks and show this through the example of a Brent oil contract. It is the most popular commodity CFD on exchanges.
For example, we decided to buy oil contracts. Oil is sold in lots, and the minimum lot is 0.1. However, since the contract itself is relatively cheap, you can safely buy a full lot or more.
For our example, I bought 1 lot. The buy price was $40.00, and the price I subsequently sold it at was $45.00. The sell price is higher than the buying price, hence I made a profit.
By the way, how many points did the price pass? 500. Why?
Because a point is the minimum price change increment on the stock exchange. Before becoming 45.00, the price rose from 40.00 to 40.01, 40.02 and so on, changing by 1 point or more.
So the profit is equal to: the price of a point (1 dollar) multiplied by (sell price (points) minus (buy price (points)), which is 1 * (4500-4000) = 500. That’s it.
If you are unlucky and the price does not go up, but the falling market occurs, your buy position generates a loss. It will be calculated using the same formula 1 * (3500-4000) = – 500. The loss in this case will be 500 dollars.
We’ve covered profit and loss, now let’s figure out how the margin works.
At the heart of CFD trading is CFD margin trading, when a trader earns based on the leverage provided by their broker. We will talk about this in detail below. However, it’s important to note that margin and leveraged trading is a double-edge sword, meaning that it could significantly magnify your profits, but, on the other hand, make your retail investor accounts lose money rapidly.
Margin lending makes it possible to work with large sums with only the minimum required deposit on the account.
Therefore a trader can work with stocks or commodities and make money on them without having the full amount to buy the underlying assets.
Let’s look at how it works using the example of stocks of one of the most popular companies in the world – Google, or Alphabet Inc.
The cost of one stock at the moment is approximately $1,445. In order to buy it, we need the entire amount. In fact, even more with the commission and spread.
But if you decide to buy not the stock itself, but a Google CFD that is equivalent in size to one stock, you will not need to have the entire sum of $1,445 in your account thanks to margin percentage.
The margin for this stock is only 2% of the total value, or $28.98. In other words, you get the same stock, only many times cheaper. tThe profit on it will be calculated as usual: how many points the price moves in your direction is how much you get.
CFD Trading Strategies for Beginners
This is one of the most important sections that will discuss trading strategy or tactics of market behavior.
A well-defined strategy will help you make money on market movements.
There are many trading strategies specifically to practise trading with contracts for difference, but I suggest you consider the most basic and accessible ones.
Short & Long CFD Trading
Let’s start our review with the most common Forex CFD strategy called “buy low, sell high”. It will look something like this in the chart:
The picture above shows two charts of market movements for 2 different underlying assets.
The top chart is Facebook stocks, and the bottom chart is stocks of the most popular online auction eBay.
As you can see, Facebook stocks were on the falling market for a long time and at some point reached equilibrium when the price stopped actively going down. This moment is called the balance of supply and demand. Very often the stock price changes after equilibrium.
In other words, if the prices have been experiencing falling markets for a long time, it will soon begin to grow. There is no other option.
After they are on the falling markets, they became cheaper and more attractive for buyers, since now less money was required to buy them. At the same time, the longer they fell, the higher the potential for future growth. Hence the first rule – “buy low”.
Another scenario is as follows: when eBay stocks are growing for a long time, sooner or later a moment should come when the major buyers will reach their targets and take their profits.
When this happens, the money supply with which they spurred growth will go away, and only the money supply of those who decided to play short selling CFDs will remain in the asset. And that’s when the money supply of sellers exceeds the mass of buyers, a reversal occurs and the stock begins to fall. Hence the second rule – “sell high”.
I think there is nothing complicated about this strategy. Everyone knows it, but this only makes it more effective. It worked 100 years ago and it works now.
Leverage in CFD Trading
This is another very important section in trading. Now is the time to talk about leverage. Leverage on Forex is an interest-free loan provided by a broker, which allows you to make trades with a volume greater than your own capital.
Without the leverage that your broker provides you, trading on the exchange for individuals would be unprofitable both for a trader and a broker. However, it’s crucial to underline that it’s possible to lose money when trading CFDs with leverage. It’s a tricky instrument that, on the one hand, helps you to increase your returns, but, on the other hand, could make your retail investor accounts lose money.
Despite the fact that trading on the world’s stock exchanges is quite active, daily price fluctuations are about one percent of the value of underlying assets. And without leverage, a trader’s income would be a few cents even in the most successful trades.
For example, you want to buy 1 share of Hewlett-Packard, which costs $18. Even on the best day, the value of the shares can change by 3-4 dollars, and therefore your income will be 3 dollars. How do you make millions on the exchange? You can only do it with leverage.
Let’s look at examples:
First, let’s look at leverage for currencies.
Let’s say we decided to make money on changes in the rates of Forex pairs. For example, we’ll take the USDCHF currency pair, which was at 1.0000 not so long ago.
We’ve decided that the rate of this currency pair will grow, and therefore we need to buy.
The base contract size for currencies is 100,000 units. In other words, a 1-lot CFD trade will generate income or loss as if from $100,000. In order to avoid giant losses in case of failure, it can be reduced to a minimum size of 0.01 lot, and then the volume of the currency will be 1,000.
We are buying 0.01 lot of the USDCHF currency pair at 1.00000 in the hope of growth. In this case, each point of long or short term price movement will bring profit or loss, depending on our lot. With a lot of 0.01, each point will be equal to $0.01.
There is a simple formula for calculating the point price. You can find it here.
After a while the price rose and the quote was 1.01000. It increased by 1,000 points. So the profit for our CFD trade will be 1,000 * 0.01 = 10 dollars.
If we use a large volume, for example 0.1, then the profit will increase 10 times and become $100, and so on. The higher the leverage, the higher the possible profit, but don’t forget about the high risk and the possibility of the margin call. In case of failure, your loss will also be leveraged and can deplete your deposit just as quickly.
Now let’s look at how leverage works in the case of contracts for difference.
Let’s analyze how leverage works for Google stocks. When trading CFDs, the minimum volume is very often one stock, in other words 1 lot is equal to 1 stock.
One stock costs $1,444, and in the case of the Forex market, we do not need the entire amount on the balance. But more on that later.
When buying 1 lot of stocks, the leverage will be 1:1 and will be regulated by a simple increase in the number of stocks bought.
If we buy 10 contracts, the leverage will be 1:10. If we will buy 100 contracts, the leverage will be 1:100. It couldn’t be easier.
The price of one point for 1 lot will always be equal to the minimum change in the stock price, i.e. 1 cent or 0.01 dollars.
Let’s calculate how much we will make if the stock rises from $1,444 to $1,450.
If we buy 1 contract, the profit will be equal to the number of points passed multiplied by the price of a point, or 600 * 0.01 = $6.
Well, of course, if you increase the leverage, you just need to buy more contracts, for example, 100, then the profit will also increase 100 times and amount to 600 dollars.
Margin in CFD Trading
Without the margin leverage that a broker provides you, trading on the exchange would be almost impossible for individuals, and brokers’ income would be almost zero.
So margin trading is good for everyone involved in the trading process. With the help of margin, experienced traders can make transactions for which their own funds would simply not be enough. However, it’s crucial to remember about the margin requirements to prevent the possibility of a margin call.
For example, you want to buy 10 Google stocks. Not everyone will be able to afford it, since one stock costs $1,445, and ten – $14,450. With the help of margin lending, I can buy 100 Google stocks with only about $400 on my CFD traders’ account.
Let’s look at an example:
Above, I already gave you the formula for calculating the margin. Here it is again:
The key parameter here is the percentage margin, it defines how much of the total value of the asset you need to have on your account to complete the trade.
For example, in the case of Google stocks, the margin is only 2% of the total value. In other words, to buy 1 stock we need only $28.89 instead of $1,444. Thanks to this, we can afford more than 30 shares with only $1000 on our account.
Hedging in CFD Trading
Now I want to tell you about a reliable strategy for trading CFDs. This is a hedging strategy. In the financial world, hedging is a way to protect capital from high risk of losing capital. In our case, we will use hedging against the possible high risk of falling markets.
The picture above shows how it works.
For example, we decided to buy Apple stock. The market rises in the chart and everything seems to be fine. But suddenly we learn that the company may have temporary problems that may be associated with a defective batch of new iPhones. This has not affected the stocks in any way yet, but it’s highly probable that it will.
There is no point in closing trades, as the problems are temporary and the price should rise in the long term. In this case, there’s a trick we can do. We go to a second account and monitor the chart with price movements.
After a while, the stock really begins to decline, and at the moment when the price reaches our buy level, we open exactly the same position on the second account (with the same volume), but this time it’s a sell position.
If the price falls even lower, profit will be generated on the second account, which will be equal to the loss on the first account.
After waiting for some time, we have a choice. We can close the profitable position on the second account and wait until the price rises and returns to profitability on the main account. Or we can wait until the price returns to the level from where we started.
The choice is yours here, but you just need to understand why you are doing this overlap. If you want to get additional profit, you have option 1, but it is risky. If you just wanted to avoid a temporary loss, you have option 2, which is called breakeven.
CFD Trading Strategies for Professionals
Now let’s talk about how CFD trading works for experienced traders. This does not mean that they are not suitable for beginners, they just require certain basic knowledge. They are often a symbiosis of basic technical analysis strategies and the contract for difference structure.
Let’s start with the most popular ones.
Rangebound (Range) Trading
The range trading strategy is perhaps the most popular one among Forex traders.
The basic principle of the strategy is based on working in the price channel. You monitor the price movements on the chart for sideways fluctuations or a corridor with a slight slope. Then you add one of the channel indicators (CCI or RSI) and compare the highs and lows in the price channel with the points where the indicator line exits the overbought and oversold zones.
If the point coincides completely, this is a signal to enter the market. If the price reached the line in the chart, but the EMA line did not reach the zone on the indicator, such a signal is insufficiently reliable and is not taken into account in the strategy.
The fractal breakout strategy is also quite popular among traders.
It is mostly used on intraday intervals.
As in the previous strategy, it’s based on a breakout of a sideways movement or a flat. Bollinger Bands and Bill Williams fractals are used as indicators.
You look for the moment in the chart when the price breaks the level of the nearest fractal and wait for the chart to go beyond the border of the nearest Bollinger band. Then the signal is considered true. Stop loss is usually set at the level of the opposite fractal.
The contrarian investing strategy is more of a fundamental strategy, since it is based not on the price chart, but on the study of the opinion of the crowd.
This strategy was first described by George Soros in his book The Intelligent Investor, where he compared the opinion of the crowd to controlled chaos.
The principle of the strategy is to find countertrend points. You find an asset that has a pronounced directional pressure and form a position against this movement.
In other words, you are making a trade against market opinion. Tesla stock can serve as an example. When it was announced last week that the company would not be included in the S&P500 stock indices, only the lazy was not selling it. This is precisely the situation for this strategy. There is a high probability of a reversal and growth in the near future.
The trend following strategy is quite popular among indicator strategies. However, in my opinion, it has a number of disadvantages compared to the channel strategy.
The principle is to open a position in the direction of a newly formed trend. You find the trend formation point based on the main signal from the intersection of the fast (21 periods) and slow (55 periods) moving averages. The signal is then filtered using two oscillators usually MACD and RSI. Make sure that the price stays within the corridor on the RSI, and the price is in the required trend on the MACD.
For example, in the case of a buy position, the fast EMA crosses the slow one in the chart and at the same moment, the RSI is inside the channel, and the MACD histogram is in an uptrend – the signal is true, you can buy. The trade should be closed when the RSI indicator exits the channel.
Scalping (aka Spread Trading)
There are a lot of scalping strategies, but I will suggest that you consider indicator session scalping, which is most suitable to trade CFDs.
The strategy is based on the comparison of signals from 4 main indicators. The main signal is from the MACD oscillator, and then we check this signal using the RSI and two MAs.
The point of the strategy is that the signal matches on all four indicators.
An example of them matching is in the chart above.
We get a buy signal when: MACD forms the first bar above the 0 level, RSI crosses the middle 50 level upwards, and the fast linear weighted moving average with a period of 10 is above the exponential moving average with a period of 26.
Swing trading is not a strategy, contrary to what many people think. Swing Trading is a complex set of rules, methods and market knowledge that together give you a clear and structured trading plan that takes into account every detail.
In general, swing trading is considered to be a trading method in which a trader keeps a position following the trend open for as long as possible, ignoring corrective movements. With the proper approach, this takes advantage not of a small piece, but of the entire trend.
Swing positions are often held for more than a month. But there are also global swing positions.
In the chart above you can see my real trade in gold, which I kept open for almost a year, adding and removing accompanying short-term trades along the way without touching the main one.
Generally speaking, I consider swing trading to be the pinnacle of the trading art, and I am going to write a separate article about this method soon.
News trading is a very popular type of trading.
As a rule, news trading is divided into 2 types: trading on periodic news and trading on events. Periodic trading is mainly done using the economic calendar. But for event trading, you need to be aware of everything that is happening around the instrument you are interested in.
For example, I chose events around Walmart Inc. At the end of August, it was announced that the company was buying the popular TikTok service and the stock began to grow actively. This is an example of a buy deal. However, a month later, news appeared in the media that the Chinese government was likely to block this deal, and the price of Wal-Mart stock began to fall actively — this is a sell signal.
CFDs Benefits & Risks
So what is CFD trading anyway and what is special in trading CFDs? A way to make money or another unnecessary financial instrument?
An analysis of the pros and cons will help answer this question.
When brokers around the world began to actively trade contracts for difference ten years ago, of course, I asked myself: “What are CFDs anyway?”.
As I studied the new type of contracts, I found a number of advantages in it over other available contracts. However, as time went on, I found obvious disadvantages as well. Let’s look at both.
I used to practise trading with CFDs. This helped me to discover four main advantages over other types of contracts:
You need very little capital to trade. I have talked about this advantage many times in this article.
The margin is the biggest advantage that makes CFD trading work almost anyone. What is a 2% margin compared to a $1,500 stock price? For some 30 dollars, I get the opportunity to earn 100, 200, 300 and even more dollars of income per day.
Very low commissions. When it comes to buying stock of a company for the long term, for a period from several months to a year, I immediately think about the fees.
These fees include acquisition taxes, commissions for inclusion in the register of shareholders, possible delivery commissions (in the case of commodities), leverage, overnight and other charges.
This set makes you think seriously before buying any instrument for your existing portfolio. However when I decide to buy a CFD, I don’t think about that at all, because all I pay is a one-time spread, a commission of 25 cents per lot, and a swap, which is less than one cent.
For example, when buying 1 Google stock contract for $1,500, you will pay 80 cents in spread, 25 cents in commission and 1 cent for ten days of ownership. And that’s it! For a $1,500 contract, you only pay $1 in commission. The conclusion is obvious.
Portfolio hedging option. I’ve already talked about hedging above. There are many derivatives for hedging, such as options and futures, but contracts for difference trading is much more affordable compared to them.
In fact, contracts for difference are the perfect way to create locks and synthetic hedging positions. But their main advantage is the ability to instantly hedge a long or short position in physical stock. I’ve described the process above.
Convenience. This item summarizes all of the above. Convenience applies to everything related to contracts for difference. This is the minimum margin, and unlimited leverage, and practically no commissions. But one advantage is worth mentioning separately – accessibility.
Forex brokers provide CFD trading on all types of instruments in one convenient and familiar terminal. You do not need to have accounts on different types of exchanges, many CFD providers have access to all types of the most popular contracts for difference.
As for the disadvantages, I have found only two. Perhaps they are not even disadvantages, but nevertheless, I recommend that you always pay attention to the little things, because they affect the result.
No legislative regulation.
I think many could say “What kind of laws are we talking about if we trade on offshore popular trading platforms and do not pay taxes?”
This is certainly true, and I am immensely glad that I don’t have to pay income tax. But I will give you the following statistics.
In recent years, cases of disputes between brokers and their retail clients concerning most CFD trades have become more frequent. This is because the broker is usually the market maker of the contracts for difference, and therefore they set the rules themselves. There is no clearly written specification of a CFD and this makes it non-standardized. In case of any dispute, the broker will always be right.
For this very reason, I strongly recommend to conduct CFD trading work with an unverified broker. It is better to choose CFD providers with a slightly higher commission, but you can be sure that you will not be deceived.
A CFD investor is not a shareholder.
Again we can say that this is not quite a disadvantage.
This may not be very important for a beginner, but it’s different for an experienced trader.
The difference between buying a CFD position and buying a physical stock is in regulation.
If you purchased a stock and entered it in the register of shareholders, you will be the owner of it until you sell or transfer it to another person. No other issues, be it flood, fire, global crisis, COVID-19 pandemic, bankruptcy of your broker or anything else, can affect this process in any way. The stock will remain yours even if the broker through which you bought it has not been a broker for 10 years.
Even if the company whose stock you have decides to close or another company buys it, you will still have the stock and it will have value.
When managing CFD work, only your broker is responsible for it. If something happens to the broker, your contracts will disappear just as they appeared.
So, once again — choose trusted brokers!
CFD Trading Platforms & Tools
Now it’s time to talk about the financial instruments you use when doing CFD trading work.
1. Trading platforms
Contracts for Difference are the most common exchange-traded contract, and therefore do not require any special software. An ordinary practice trading terminal offered by your broker is quite enough to manage CFDs work.
The most popular platform, of course, is the MetaTrader 4 trading terminal. In my opinion, there is no better trading terminal. It has everything you need for trading, a large set of technical analysis financial instruments, and the ability to download historical charts.
There is also a new version of this terminal, MT5, but it is not as popular as 4.
There are several quite convenient online platforms that have recently begun to appear. Their advantage is convenience, since the platform is built right into the trader’s personal account, and the owner has instant access to all the opportunities of interacting with the broker.
2. Trading tools
Tools are all the additional features that your broker provides.
This includes economic calendars and free access to the necessary analysis. Only very reliable authorized financial service providers can ensure that since not everyone can afford their own analytical department. There are additional programs, which include the trader’s calculator that I have already described. You can also add news feeds, which are necessary for news traders.
3. Graphical analysis elements
Such tools are usually built into the trading platform. But time does not stand still and new trading indicators or graphic elements are constantly appearing. You need to download, install, and practise trading with them in your trading terminal.
4. Trading advisors
These tools are essential to automate your trading. Trading with trading robots is called algorithmic trading. Their advantage is that they do most of the work for the trader, from looking for signals to enter the market, to fully automated trading without the participation of the trader.
A successful trader has the entire set of tools in their arsenal. Leading brokers know this and try to offer their clients this set in one place and on one platform.
As I have said more than once, I choose LiteFinance — a broker with 15 years of experience in the financial markets.
I have been working with this broker for over 5 years, after trying many different brokers before that.
The main advantage of LiteFinance is its accessibility.
Everything you need is in one place.
The structure of the website is user-friendly – you don’t have to go through a bunch of links to get where you want. You get everything you need in 2 or 3 clicks.
And as a specialist, I am absolutely satisfied with the trading conditions, commissions, and the server’s response to instant price changes or slippage. Also, the company allows scalping and swing trading.
CFD Rules & Tips
Now let me give you some tips for building your own successful trading strategy. No matter how trite it may sound, any trading strategy is a set of rules. Let’s make the rules:
1. Always follow the rules!
The first and foremost rule is to always follow the rules of your trading strategy. Any slip-up or indulgence is guaranteed to lead to a loss or problems.
2. Use restrictive orders
When trading CFDs, you will most often deal with stocks, and trading in stocks is strictly timed. There will be breaks in trading, after which unexpected price changes may occur. To prevent these changes from hitting your wallet, you must always remember to limit risks.
3. Don’t be afraid to make decisions
I know from my own experience that you will never create a successful investment strategy if you are afraid to make a mistake. Without mistakes, you will never learn. To avoid fatal mistakes, see point 2.
4. Watch your leverage
Always keep your leverage in the planned range before opening a trade and don’t do anything you did not plan in advance.
In other words, if you are in a trade, and an event occurs that confirms your prediction, you should not increase the position size if you have not planned it in advance.
5. Calculate your trade before you open it
Before you open a trade, you must clearly know what purpose you are pursuing and how much you will lose if something goes wrong.
6. Never listen to anyone
If someone tells you that they earned millions on Bitcoin, this does not mean that you should drop everything and buy Bitcoin. Remember, most rumors are created on purpose, and they will not bring you any profit. If someone tells you that LiteFinance is a good and reliable broker, do not just blindly trust them – do your own research and make your own conclusions.
7. Use trading breaks
You shouldn’t be in the market all the time. Take breaks, your body really needs them. Fatigue leads to mistakes. It is especially helpful to take breaks after bad trades.
8. Analyze your mistakes
To prevent the further risk of losing money rapidly, after you have made a bad trade, determine whether it was your own mistake or it was a trivial market risk. If there was a market error and you closed a trade with a loss, but within your own rules, give yourself some credit, because even in this difficult situation you remained true to your strategy.
Market mistakes do not happen so often, and if you are always ready for them, your profit will grow.
CFD Trading vs. others financial instruments
All that’s left is to compare CFDs with other instruments offered by the exchanges and brokers.
CFD vs. Share (Stock) Trading
When comparing stock CFDs and physical stocks, there are several things that should be mentioned:
Pros of CFDs:
- Minimum margin requirements;
- Unlimited leverage;
- No commissions and taxes;
- Ability to open short selling CFDs;
- Possibility of hedging.
Pros of physical stocks
- Transactions are strictly regulated by law;
- Can be a collateral asset in financial disputes;
- In case of liquidation of the broker, the stocks will remain;
- The owner is a voting shareholder of the company.
CFD vs. Spread Betting
When comparing CFDs and spread betting, there are several things that should be mentioned:
Pros of CFDs:
- Minimum margin requirements;
- Unlimited leverage;
- No commissions and taxes;
- Regulated by the law “on dealer activity”;
- Possibility of hedging.
Pros of spread betting:
- The client sets the size of the trade;
- Ability to trade the difference in spread.
Cons of spread betting:
- There is no regulatory framework;
- Activities equated to bookmaking;
- Upper threshold for profit.
CFD Vs. Futures
When comparing CFD trading with buying futures contracts, there are several things that should be mentioned:
Pros of contracts for difference:
- Minimum margin requirements;
- Unlimited leverage;
- No commissions and taxes;
- Ability to open short contracts;
- Possibility of hedging;
- High liquidity;
- The contract has no time limit.
Pros of Futures Contracts:
- Possibility to hedge the underlying asset;
- Strict regulation by law;
- Ability to open short contracts;
- Guaranteed fulfillment of obligations under the contract.
CFD vs. Options
When comparing CFD trading with buying option contracts, there are several things that should be mentioned:
First I should say, if there were no CFDs, I would have called options the best financial instrument in history without hesitation.
Pros of contracts for difference:
- Minimum margin requirements;
- Unlimited leverage;
- No commissions and taxes;
- Ability to open short contracts;
- Possibility of hedging;
- High liquidity;
- The contract has no time limit.
Pros of Option Contracts:
- Possibility of very cheap hedging of the underlying asset;
- Strict regulation by law;
- Ability to both sell and buy a contract;
- Guaranteed performance of obligations under the contract;
- The best built-in loss limitation system among all exchange instruments.
Cons of Option Contracts:
- Low liquidity;
- Please note! Binary Options trading is an unregulated shadow OTC-market. There’s a high chance of coming across a fraudulent financial service provider.
Summing up, I would like to say that CFD trading is an ideal option for beginners and traders without a significant capital. Traders with a large amount of funds at their disposal in the existing portfolio may choose to buy the underlying asset itself due to insufficient legal regulation and high risk of losing money associated with the use of leverage.
When making a choice in favor of contracts for difference, it’s crucial to remember the risks associated with CFD contracts. Without a robust risk management plan, retail CFD traders’ accounts may start losing money rapidly. If you decide to opt for low fees and low cost, then CFDs provide an excellent alternative to most other trading methods.
Nevertheless, remember that the only measure of success for any trader is only the amount of profit, and the instrument of choice is ultimately irrelevant.
But enough conversations, it’s time to get to work. I wish you good luck. If you have any questions, I am always happy to help!
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The content of this article reflects the author’s opinion and does not necessarily reflect the official position of LiteFinance. The material published on this page is provided for informational purposes only and should not be considered as the provision of investment advice for the purposes of Directive 2004/39/EC.