What Are CFDs and How Do They Work

When trading shares or commodities or crypto etc. normally you have to actually own the asset, but with CFDs there is a way around. You don't need to own shares or barrels of oil, instead you just bet on which way the price will go, and you win or lose depending on whether you were right. Observations have proven that significant number of traders prefer CFD trading over other financial instruments.

Simple yet plenty to learn. Let's go

What Are CFDs

CFDs are contracts between you and a broker to swap the difference in the price of a financial instrument between the moment you open the trade and the moment you close it. If the price goes your way, the broker pays you the difference. If it goes against you, you pay the broker.

The key point is that you never take ownership of anything. Say you open a CFD on Apple shares. You don't get a share certificate, you don't get voting rights, and the shares never land in your account. You just hold a contract that tracks Apple's price. The same goes for CFDs on the FTSE 100, the euro against the dollar, gold, oil, or Bitcoin, you get the idea. Brokers offer thousands of these markets.

CFDs were first developed in London in the early 1990s as a tool for big institutions, and they spread to ordinary traders when online brokers took off in the 2000s. Today they are popular in the UK, Europe, Australia and parts of Asia. They are banned for retail customers in the US, mostly because of regulations that limit this kind of over-the-counter product.

How Do CFDs Work

Let us explain it with an example.

Suppose Apple trades at $200 a share and you think it will go up. You buy 100 Apple CFDs. The full value of that position is $20,000.

You don't need $20,000 to do this. In the UK and EU, brokers must follow rules set by regulators that limit leverage for retail clients. For individual shares, the limit is 5 to 1, so you only need to put up 20 percent, which is $4,000. That $4,000 is your margin, basically a deposit that keeps the trade open.

Now two things can happen.

If Apple rises to $210, your 100 CFDs are worth $1,000 more. You close the trade and keep that $1,000, minus costs. That is a 25 percent return on your $4,000 deposit, even though the stock only moved 5 percent.

If Apple falls to $180 instead, you lose $2,000. That is half of your deposit gone from a 10 percent drop in the share price. If it keeps falling, the broker will ask you to add money or will close your trade automatically to stop the loss from growing past what you put in.

That is leverage in action - small price moves matter a lot, in both directions.

You can also go the other way - going short. Say you think oil is overpriced at $90 a barrel. You sell an oil CFD. If oil drops to $80, you make money on every barrel your contract covers. If it jumps to $100, you lose. With normal share buying, profiting from a fall is much harder.

Then there are the costs, which new traders often overlook:

• The spread. Every CFD has a buy price and a slightly lower sell price. If Apple is quoted at 199.95 to 200.05, you start the trade a little in the red and the price has to move for you to break even.
• Overnight financing. Because you are effectively borrowing to hold a bigger position than your cash covers, the broker charges a small daily fee if you keep a trade open past the market close. Hold a trade for weeks or months and this adds up.
• Commissions. Some brokers charge a fee on share CFDs, a small percentage of the trade.
• Dividends. If you hold a long CFD on a share that pays a dividend, you typically receive a matching payment. If you are short, you pay it.

CFD trading platforms also let you set a stop-loss, which closes your trade automatically if the price hits a level you choose. For example, you could buy Apple at $200 and set a stop at $190, so your loss is capped at about $1,000 plus costs. It's not a perfect safety net, since prices can jump past your level overnight or on big news, but it is one of the most useful tools you have.

Why Trade CFDs

People use CFDs for a few practical reasons.

Access - with one account, you can trade US shares, European indices, currencies, gold and crypto without opening separate accounts in different countries or dealing with different currencies and exchanges. Many CFD markets are open nearly around the clock on weekdays, so you can react when news breaks in the evening.

Flexibility - being able to go short is a big advantage. If you think a stock is overvalued after a big price increase, or expect market to fall after a poor jobs report, you can act on that directly. Investors with a long-term share portfolio also use short CFDs to hedge. If you own a lot of tech stocks and fear a short-term drop, a short CFD on the Nasdaq 100 can offset some of the loss without selling your shares.

Lower cost - because of leverage, you can take a meaningful position with a smaller amount of money. On the FTSE 100, for instance, you might trade at £1 per point. If the index is at 8,000 and moves to 8,100, you make £100. For someone who doesn't want to buy a big basket of shares, that is quite convenient.

Conclusion

CFDs are straightforward, you trade the price of an instrument without owning it, using a small deposit to control a bigger position. That makes it easy to bet on prices going up or down, and easy to reach markets from all over the world.

If you want to try CFDs, start small, use a demo account first, always set a stop-loss, and only risk money you could afford to lose.

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