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What is CFD trading and how does it work?

CFD stands for contract for difference, and these are financial derivatives used in the world of trading. In brief, the contract is an agreement between a trader and a CFD broker, and is based on the difference in value between opening and closing the contract.

CFD trading contrasts with traditional trading, as there’s no ownership of the underlying asset, allowing trade on both rising and falling markets. You can also gain greater exposure to the market through leverage trading.

This type of trading can be complex, and does come with its risk, so you should always consider whether you understand how CFDs work, and whether it suits your level of risk.

If you are thinking of including CFD trading as part of your portfolio, read on to find out more about this increasingly popular form of trading.

How does CFD trading work?

You can access the global markets through CFDs, and can trade a range of assets, such as shares, indices and commodities — and usually all from one trading environment through an online CFD trading platform.

CFDs allow you to speculate the price movements of a particular asset or market, but as previously mentioned, does not involve ownership of the underlying asset. Instead, you trade your chosen number of contracts, sometimes known as units. The price of the CFD is reflective of the underlying asset, and mirrors its movement at all times.

Due to the nature of CFDs, you can speculate on both a rising or falling market. Your prediction of the market movement will influence if you take a short or long position. This means, when you believe the prices to rise, you would buy CFDs. Alternatively, if you expect the prices to fall, then you would sell CFDs.

The profit or losses depend on the market conditions, the size of the position you take, and the leverage ratio (which we will go on to explain later). The results are based on the difference in price between the initial value of the CFD bought or sold, and when the trade is closed.

What is leverage?

CFD trading often involves leverage, but the maximum offered can vary across different brokers, trading platforms and instruments. Leverage trading enables you to enter a larger position in the market with less capital initially required.

With leverage, you can deposit a percentage of the position, with the rest needed to execute the trade borrowed from the broker. It can be a benefit of CFD trading, as it has the potential to magnify the profit on your investments. However, as the results are proportionate to the total value of the trade, it can also magnify any losses incurred. It is therefore always important to fully understand leverage before trading, as well as having risk managing tools in place.

How does this work in practice? Let’s take the example of a leverage ratio of 100:1. The ratio measures the total exposure to the market compared to the capital required by the trader. In this case, in order to trade £100,000 worth of an asset, only £1,000 would be needed.

The benefits of CFD trading

We’ve already covered some of the benefits of CFD trading, such as the ability to open either short or losing positions, and the use of leverage trading. But other advantages of CFD trading include:

• Quick and easy accessibility

CFD trading allows you to trade the various types of markets, at any time. This means that you can even access the markets outside of the traditional trading hours. As CFD trading takes place through an online platform, your trades will also be executed quickly and efficiently.

• Prevent potential losses with hedging

This type of trading also offers the opportunity to hedge against losses when owning the underlying asset. For instance, if you were to own the shares of a company in the traditional sense, then you can use stock CFDs to short them, if you believe that the prices will fall. If your prediction is correct and the prices drop, you would make profit from the position you opened using CFDs.

• Free demo account

Another benefit of CFD trading using an online platform, is the fact that you can often make use of a free demo account. This means you can try out your strategy and techniques for your chosen market, before moving onto real capital.