What is CFD Trading and How Does It Work?  

Have you ever wondered how CFD trading works and how it could potentially help you grow your capital?  

In this comprehensive guide, we’ll walk you through everything you need to know about Contract for Difference (CFD) trading. 

What is CFD? 

A Contract for Difference (CFD) is an agreement between a trader and a broker. This contract allows the trader to speculate on the price movements of an asset without owning it. The difference in the asset’s price from the opening to the closing of the trade determines the profit or loss. 

How to calculate the cash settlement? 

The cash settlement amount is calculated using the “difference” between the price at the opening and closing of the trade. 

Do we trade the asset itself? 

CFD trading is a way of trading the value of the underlying asset, not the asset itself. The “derivative” nature of CFDs makes them extremely versatile, which has led to the market, first developed in the 1990s, growing into a multi-billion dollar market. 

Why trade CFDs? 

CFD trading offers unique advantages for traders: 

• If you are looking to trade a wide range of markets with leverage, CFDs may be better for you.  

• CFDs are useful if you are a short-term trader because CFD trading allows you to speculate on the price of an asset by buying or selling. 

• Using CFDs allows traders to trade a wide range of asset classes, including indices, forex, stocks and commodities. 

• It also allows investors looking for new markets to trade different asset classes in a user-friendly and less capital-intensive way. The process of booking a trade is the same, whatever your target market. 

What is Long and Short Selling in CFDs ? 

When you trade CFDs, you can speculate on price movements in either direction. If you think prices will rise, this is known as “going long”. If you think prices will fall, this is known as “going short”.  

So, if you feel the price of a share will fall, you can sell it short by selling CFDs. 

Where in short selling CFDs, if a trader believes that a market is overvalued, they can sell. It also allows investors to profit from downward price movements, as they can implement a stop loss when opening short selling positions instead of following the traditional ‘buy and hold’ approach, which mitigates losses and helps manage risk. 

Example: If you anticipate the price of gold will increase, you buy CFDs. If you expect a decrease, you sell CFDs. 

What are the 3 CFD trading essentials? 

1. Trading on the Difference: Speculating on price movements without owning the asset. 

2. Leverage: Amplifying market exposure with a smaller capital outlay. 

3. Diverse Asset Classes: Trade in various markets including forex, indices, commodities, and more. 

Leverage and Margin in CFD Trading 

What is Leverage CFD? 

Leverage is a key feature of CFD trading – allowing you to open positions by paying a fraction of their full value, known as your margin. 

And In CFD trading,  

leverage is the ability to trade without paying the full value of your position upfront. Instead, you only have to pay a deposit called your margin. 

How does it work? 

• With leverage you don’t have to pay the full value of your chosen asset directly, because you essentially don’t own the asset you are buying and selling. All you do is speculate on the price movements, up or down. 

• The benefit of leveraged trading is that it allows you to gain the same amount of exposure to the market by depositing only a small portion of the total value of your trade. So you can use your money elsewhere. 

What is Margin in CFD ? 

Margin is the deposit you will need to put into your account to trade a CFD. You will also see it referred to as the market margin factor or margin requirement. 

Margin factors vary across markets and are usually given as a percentage. The percentage tells you how much of the full value of your position you will need to deposit. Generally, the higher the requirement, the more volatile or illiquid the market. 

What is a Margin Call? 

• A margin call is the call your broker makes when your position is at risk of being closed or liquidated, in order to keep your leveraged trade open. 

• The broker closes positions after your funds fall below 100% of your trading margin requirement. 

Example: 

Let’s say you deposited only $750 to buy CFD XYZ. If the price of XYZ stock drops and your position becomes -$50, you will only have $700 of equity in your account, which is not enough to cover your margin requirement.  

To avoid liquidation, you should always ensure that you have enough funds in your account to cover your maximum loss for the period you decide to keep your trade open. 

What should you do if you are close to liquidation? 

• Close your trades 

• Acknowledge the loss 

•  Reduce your overall margin requirements 

• Add additional funds to your account. You will need to cover the margin deficit, 

Step by Step guide to CFD trading  

Step 1: How CFDs Work 

CFD trading is the selling and buying of contracts for difference, which are financial derivatives in which you agree to exchange the difference between the opening and closing price of a particular financial asset, such as a indices, stock, or commodity. 

Unlike buying shares, you don’t acquire ownership of the underlying asset. You never own the stock you are trading. 

Step 2- Open an Account 

To buy and sell CFDs, you’ll need an account. This is what you’ll use to look for new opportunities, open and close positions, manage risk, monitor profit and loss and more. 

When you’re ready to risk some of your real capital, you can open a live account, then, once you’ve added some funds, you’re ready to get started. 

Step 3- Choosing a CFD Market 

Choosing a CFD market involves considering factors such as market volatility, liquidity, trading hours, your risk tolerance, and investment goals. 

Popular CFD Markets: 

• Forex: Offers high liquidity and 24/7 trading. 

• Indices: Tracks the performance of major stock markets. 

• Commodities: Includes gold, oil, and agricultural products. 

• Stocks: Trade individual stocks or baskets of stocks. 

• Cryptocurrencies: Offers high volatility and 24/7 trading. 

Step 4- Decide whether to buy or sell 

Two prices: CFDs have a “bid” price (short selling) and an “ask” price (short buying), with a slight difference between them called the “spread”. 

Both are based on the price of the underlying instrument. The bid price is always slightly lower than the market price, while the ask price is slightly higher. Before opening your position, you will need to decide whether you want to buy or sell. 

Trade direction: You “buy” if you think the price will go up and “sell short” if you think it will fall. 

Shorting means you make a profit if it falls in value, and a loss if it rises.

Step 5- Select how many CFDs to trade 

Once you have chosen your market and decided whether to buy or sell, decide how many lots you want to buy or sell. 

Each lot represents a certain amount of its underlying asset. For example, in the case of stocks, a CFD is equivalent to one share. To find out what a contract means for your market, look for the “tick value” in the instrument’s market information sheets. 

US CFDs are traded in the underlying asset (e.g., US dollars for US stocks). 

Step 6-adjust Leverage and Margin 

Leverage allows you to trade with a small portion of the total trading value in your account to open a position, known as margin. The higher the value of your trade, the higher the margin required. 

You must have sufficient funds to meet the margin requirements. The trading platform’s margin calculator will automatically determine the amount required to open a position. 

Step 7- Add stop and limit orders(manage risk) 

Before you place your trade, it’s essential to consider your risk management strategy.  

A key risk management technique is to set an order, like a stop-loss, which will automatically close your position if the market reaches a specific price. 

A stop-loss order instructs your broker to close your trade once it reaches a price level you set. As the name suggests, this will be at a price worse than the current market level and is typically used to limit potential losses if a trade moves against you. 

A limit order, on the other hand, instructs your broker to close a position at a price better than the current market level. It’s commonly used to secure profits. 

Both stop-loss and limit orders are free to set and can be added to your trade when you initially place it or after it’s open. 

Once you’ve set up your risk management, you can execute your trade by clicking ‘Place Order’. 

Step 8- Monitor Your CFD Trades 

Now that your position is open, your profit or loss will fluctuate as the underlying market moves. 

You can track market prices, view real-time updates on your profit or loss, and modify or close your position from your computer or mobile app. 

If you haven’t set a stop-loss or limit order before opening the position, you can still add them now. And if you already have exit orders, you can adjust them to reflect changing market conditions. 

Step 9-Closing your trade 

To close a CFD position, you simply need to execute a trade in the opposite direction of your original trade. If you initially bought 500 CFDs, you would now sell 500 CFDs. 

You can do this by selecting the “Close Position” option within your positions window. 

Your realized profit or loss will be immediately reflected in your cash balance. 

To manually calculate your profit or loss, subtract your opening price from your closing price (or the opposite for short positions), and then multiply the result by your position size. Remember to take any costs into account.

What are the advantages and disadvantages of CFD trading? 

​​Advantages	​Key Aspects	​Disadvantages
​CFDs allow short-selling, enabling traders to profit from both rising and falling markets. This flexibility offers expanded trading opportunities.	​Profit from Falling Markets	​Leveraged positions amplify both gains and losses, increasing the risk of significant losses.
​Leverage allows traders to control large positions with a small deposit, optimizing capital usage.	​Capital Efficiency	​Leverage can lead to losses exceeding your initial deposit if not managed properly.
​CFDs mirror traditional assets, making it easier for traders familiar with stock or forex trading to transition.	​Similarity to Traditional Trading	​Unlike traditional investing, you don’t own the underlying asset, missing out on dividends, voting rights, and long-term growth benefits.
​CFDs mirror traditional assets, making it easier for traders familiar with stock or forex trading to transition.	​Similarity to Traditional Trading	​Unlike traditional investing, you don’t own the underlying asset, missing out on dividends, voting rights, and long-term growth benefits.
​New traders can use a demo account to learn platform features, practice strategies, and build confidence without financial risk.	​Hedging Capabilities	​Demo accounts lack the psychological aspects of real trading, which can make transitioning to live markets challenging.​