CFD Trading For Beginners: What Is It And How Does It Work?

CFD Trading For Beginners: What Is It And How Does It Work?
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What is CFD trading?

Contracts for difference (CFD) is a form of derivative that lets traders speculate on the price movements, up and down, of different fast-moving global money and commodity markets such as indices, forex, treasuries, and shares.

The primary difference between CFDs and traditional markets is that you don’t have to own the financial instrument. Additionally, contracts for difference are entered into with a broker and not the market in which the instrument is traded.

CFD trading, therefore, refers to a trading agreement between a broker and trader where they agree to mimic the live market conditions and settle the trade differences arising between the time of opening and closing a trade.  As the name suggests, CFD trading involves entering into a contract with your broker where you exchange the difference in prices arising between the time of opening and closing a trade.

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How does CFD Trading work?

CFD trading involves taking up a position, often referred to as entering into a trade, by selecting the number of CFDs you are interested in trading and waiting for the market to go in your favor to enable you to realize profits. Your forecast and take profit position can involve the price going up or down.

And if your forecast and price action analyses show a higher probability of price going up, you click to buy, go long. The higher the price goes up in such a case, the larger your profits.

If on the other hand, you fail in your analyses or unexpected news and events change the course of the trade’s price action movement and it goes south, you will make a loss for every point it covers against your entry price.

The same principle applies to sell orders that you get into with the anticipation of a falling CFD price. If it performs as planned, you will gain for every point it falls below your entry price and vice-versa.

A CFD Trade Example:

For example, if you expect the price of Amazon shares to go up, then you can enter into a trade by buying 5 CFDs at the price $2030 with Plus500. If the shares really did go up and their market rose by 20 points to $2050, you would have made $100 (5*20=100). If on the other hand, the price of these shares fell by 20 points to $2010 by the time you liquidate the contract, you would have made a net loss of $100.

Note that instead of sell and buy orders, most brokers will often use such terms as going long or short in trade. Going long here means expressing optimism in a security, and buying with the expectation that it performs well while going short on a trade implies pessimism with the trade where you expect it to fall below its current price.

Similarities and difference between CFDs and traditional financial instruments exchange

Apart from the fact that you don’t get to own the financial instruments or that you can go long or short on any CFD asset, there are a host other differences between the two forms of trade. For instance, CFDs are subject to such factors as spreads, leverages, and margins.

One of the key similarities between the two forms of trade, however, is the fact that they both support hedging. They also don’t have time limits or expiry period for trades entered.

Factors affecting CFD trading

1. Spreads

A spread is the difference between the market Bid and Ask prices. When entering into a trade, you will have to pay the Ask price and when closing your order get the bid price. Ideally, high-liquidity markets like forex are often associated with lower spreads while low liquidity markets have the highest spreads. For instance, the spreads for EUR/USD (the most traded currency pair) at Plus500 is set at 3 pips while that of EUR/JPY stands at 9 pips. Ideally, the higher the spreads the lower the profits.

2. Leverages

Leverage in CFD trading refers to the amount of loan capital that a broker is willing to advance you in order to facilitate your big trades. If you wished to buy $10,000 worth of Apple shares in the conventional securities market, you will be required to deposit $10,000 to the seller’s bank account. When trading CFDs however you can make a similar purchase with just $100 in your trading account as your broker loans you the balance. Leverages are expressed in ratios such as 1:100 or 1:500, implying that for every dollar you deposit, your broker will multiply your deposit hundred or five hundred times.

3. Slippage and requotes

If you hope to enter into a trade at $10 but the markets moved up or down significantly by the time your broker receives your order, they may send a revised quotation, referred to as a requote, expressing their inability to enter into a trade at your desired price. Slippage, on the other hand, refers to the marginal difference between the price at which you wish to enter or exit a trade and the actual price at which the order hits the market. Slippage is more common than requotes and often in negligible amounts.

4. Hedging:

Hedging is the art of entering into two correlated trades with the hope that a profit in one offsets the losses in another. It is a risk management tool. For instance, if you have 100 Facebook shares but fear that recent fines and privacy laws may affect their performance adversely, you can decide to short them with 100 CFDs Facebook shares. Should the Facebook shares perform dismally, you lose the value of actual shares but gain with your CFD trade.

What is the cost of trading CFDs?

Cost of trade refers to how much a trader has to pay to successfully execute a trade. It includes the actual cost of your desired financial instrument as well as the brokerage commissions and other non-trading fees and charges. They include:

  • Brokerage fees: CFD brokers often express their charges for trade facilitation in the form of spreads or commission or both depending on the trading account. Plus500, for instance, operates multiple accounts where fees are expressed in the form of both spreads and commissions.
  • Overnight charges: CFD brokers will also impose a charge on every order that remains open by the end of the day, often referred to administration fees. This can be either a fixed charge or a percentage of the value of the trade.
  • Non-trading fees: These include withdrawal and deposit processing fees charged by the broker or the payment service provider. And while they don’t have a direct impact on the trade, they play a key role in influencing your trade volumes as well as profitability. It also covers the cost of converting the currency to your broker’s base currency.

For example: If you hoped to purchase 10 Apple share CFDs with Plus500 whose Ask price is $300 each, you are expected to have $3000 ($300×10) in your trading account. When making the deposit, however, you have to take into account your payment processing provider’s fees. If you liquidate the trade before the end of the day at a bid price of $310 per share you would have a balance of $3100 ($310×10). Should you withdraw the amount, you will receive $3075 in your bank or electronic wallet. The trading cost here includes the difference in spreads as well as the deposit and withdrawal fees.

What makes CFD trading popular with investors?

  • Unlike the conventional market trades, CFDs aren’t subjected to such additional costs as stamp duty.
  • It also operates in one of the most volatile and in effect the fastest markets. It doesn’t require paperwork or lengthy payment authentication processes. You just have to fund your trading account and enter or close trades with a few keyboard strokes.
  • The fact that you can benefit from a rising or falling price of the differences by going long or short is also unique to the CFD markets.
  • It also presents you with one of the widest market reach and the largest pool of financial instruments.
  • The availability of leverage and margin trading further makes it possible for traders to invest and profit from large trade deals with minimal capital.
  • The fact that there are no trading requirements for participants or minimum balances makes it inviting to virtually everyone.

Risks and demerits of operating a CFD account

  • Leverage may be the greatest CFD trading feature but it is also the biggest threat to the trader’s capital as it often leads to negative balances.
  • You also stand to lose all your deposits and profits accrued therein, should your CFD broker go under.
  • A lag in your CFD broker systems that results in slow order execution speeds that in effect cause significant slippage losses.
  • Lack of proper regulation encourages brokers to force high spreads on the traders that eat up their profits.
  • High incidence of loss where between 60% and 90% of all retail CFD traders lose money, with different CFD brokers.

How much do you need to start CFD trading?

One of the factors influencing the establishment of the CFDs market was the need to eliminate such barriers to trading financial instruments as access to the market, legal bureaucracy, and minimum investment capital. Most of the brokers have therefore created trading accounts to suit these needs by eliminating minimum deposit amounts or maintaining them at affordable levels of $1, $5, or $10 for most standard and micro-accounts.

Note that Professional client traders operating ECN and share accounts are however required to maintain high account balances to cover up for the huge leverages advanced and above-average market volatilities. For instance, you don’t need a minimum balance to operate a live account with Plus500 brokers.

What to look for in a CFD trader

While the CFD markets feature highly on the list of the largest global markets, there is no unified global regulatory body charged with overseeing their operations. This has not only encouraged the sprouting of scam CFD brokerage houses but also the continued operation of others of ill-repute. And given the significant role the broker plays in influencing the returns on your investment and the security of your deposits, it is imperative that you only trade with the best CFD brokers in the industry. How then do you identify reliable trader?

1. Ensure they are regulated

Finance regulatory agencies scattered all around the world are charged with the responsibility of vetting the legitimacy and monitor the conduct of the different finance brokerage firms. These can enforce legitimate trading practices on CFD brokers operating within their jurisdiction. Do not register an account, provide personal details, or deposit funds with an unregistered and unregulated CFD broker.

2. Check their trading costs

The last thing you need is a CFD broker that keeps shooting additional trading costs at your trades and profits. Note that while the spreads and commissions may seem friendly and competitive on the surface, some brokers are known to sneak in additional cost in the terms of conditions, taking advantage of the fact that most people never read through them. Go through these terms before signing up with a broker or committing your funds and identify possible hidden costs.

3. Vet their reputation

CFD experts and traders who have interacted with different brokers are always voicing their opinions and concerns about a broker online. Go through the different independent and unbiased CFD brokerage review sites and use the reviews to gauge your preferred broker’s reputation.

5. Check the number of instruments listed

A broker’s reliability should extend to their ability to provide their clients with a wide range of financial instruments to choose from. This ensures that you don’t end up settling for low liquidity and high spread markets due to the limited number of instruments and market access provided by the broker.

6. Open a demo account

The surest way of gauging a CFD broker’s transparency and reliability is by opening a demo account with them. While you can’t use the demo to test their transparency in the computation of trading cost, it becomes handy in testing every other factor that makes a good broker. These include their order execution speeds, quality of customer service, gauge the average spreads for different markets, and practicability of such trading techniques as scalping.

FAQs

Are profits from CFD trading taxable?

Profits earned from CFD trades are considered an income and different countries treat these incomes differently. Plus500 recommends that you consult a tax consultant or agent in your country for advice on how to treat this income.

Must I use leverage when CFD trading and is it flexible?

The use of leverage funds isn’t mandatory in CFD trading. However, most forex brokers, including Plus500 encourage its active use by all its clients operating various CFD accounts. You nevertheless don’t have to feel obliged to trade the leverage to its entirety for every trade.

Can I lose more than my deposits in CFD trading?

Yes. It is possible to lose more than the deposited amounts with your account dipping into negative balances. This, however, will only occur when you either use a broker without stop-loss risk management features or negative balance protection.

How does CFD copy trading work?

Copy trading CFDs is a part of the larger social trading where beginner traders copy trade settings of profitable trades from more experienced traders and replicating them in their accounts, thereby scoring similar profits.

Why should I trade CFDs and not conventional markets?

CFD trading presents you with some of the most flexible trading platforms free from regulatory bureaucracy and capital limitations that place the conventional markets out of the ordinary traders reach. Benefits of trading CFDs and not traditional markets also touch on fast capital liquidation and access to the markets from any part of the world on the mobile trading platforms.

How can I start CFD trading with Plus500?

Opening a CFD trading with Plus500 is relatively straightforward as it only involves signing up and identity verification. You also don’t need a minimum operating balance to maintain a live account with the broker. Inexperienced traders are, however, advised to start by opening an Plus500 demo account that helps them familiarize themselves with the trade and broker’s operations.

Where can I trade?

CFD trading is highly versatile and can be traded on multiple platforms including MT4, MT5, ZuluTrade, cTrader, and WebTrader. These are also accessible on PC and mobile phones.

 

20 thoughts on “CFD Trading For Beginners: What Is It And How Does It Work?

  1. I was really excited about trading on eToro but then I realised that you need at least $250 to actually start trading and I really cannot afford to spend that much just to get started. Are there other brokers that will allow me to trade CFDs but that require lower deposits?

    1. Hello Mattia. Thank you for your question. Yes, there are other brokers that require lower fees. You can have a look our CFD brokers page to find out what these are. However, be aware that quite often, the brokers that do not require such high initial deposits have higher fees so you will end up more than you would spend on eToro, which has very limited fees. So we recommend waiting until you can afford higher deposits at the beginning so that you can sign up on eToro and save up money in the long term.

  2. I can’t wait to start CFD trading on eToro, I’ve heard great things about it. I am kind of new to this whole thing though, so I was wondering if someone could please walk me through the sign up process on the platform.

    1. Hello Charlie. Thank you for getting in touch. To sign up on eToro, all you have to do is go on the official website and sign up. You will have to type in your email address, password, full name and phone number. You will then have to provide proof of your identity with a copy of your passport and a document to prove your address. It will take the system a couple of days to verify the documentation you provided. Once that is done, you can deposit funds into your account and then start trading. If you want the details on how to sign up on eToro, feel free to check out our eToro review.

  3. I assume there are some positive and negative aspects of CFD trading. Can someone tell me what these are?

    1. Hello Josefine. Thank you for your question. The positive sides of trading with CFDs are that they are not subjected to certain additional costs such as stamp duty. They do not have to be dealt with paperwork, everything is done quickly and online. You can also benefit not only from a rise in prices but also from a decrease by going long or short. It is accessible by everyone and leverage and margins help make significant profits even with small capitals. As for the downsides, using leverage can be very dangerous because it can result in huge capital losses. Brokers are often subjected to hacking attacks. Brokers can impose very high spreads, especially if they are unregulated. In general, CFD trading is considered a “high risk” activity.

    1. Hello Becky. Thank you for your question. CFD copy trading is an option that very few brokers on the market offer. One of these is eToro and it is also one of the reasons why we recommend it as one of the best CFD brokers to trade with. The copy trading option is perfect for inexperienced users because it allows them to see the trades places by the top ranking investors on eToro and you can place the same investment. This not only increases your chances of making profits but it gets you started on developing a trading strategy that you will be able to use once you are more familiar with the whole thing.

    1. Hello Artyom. Thank you for your question. They both carry the same amount of risks. Both of them refer to highly volatile markets. Forex and CFD assets are very unpredictable and often even professional users run into losses due to the difficulties of predicting whether the value of an asset will decrease or increase. So when it comes to CFD and forex trading, be equally cautious. To find out more about forex, feel free to check out our forex trading page.

  4. Is it expensive to trade CFDs? The thing is that my budget is not that high, so if I do not see any returns soon, I might have to give it up earlier than I’d like to.

    1. Hello Chris. Thanks for your question. It is not more expensive than any other kind of online trading. Other than the amount you invest, there are fees you should be aware of when trading CFDs. The fees you should know about are brokerage fees, overnight charges and non-trading fees. With brokerage fees, we refer to the fees charged by the broker in the form of spreads or commissions. The overnight fees are also charged by brokers for trading positions held overnight. There are also non-trading fees charged for withdrawals and deposits. I hope that answers your question.

  5. Are there any criteria I should keep in mind to choose the best CFD broker for me? I would really like to start trading CFDs but I cannot decide which platform to do it on.

    1. Hello Adrian. Thank you for your question. Yes, the first thing we look at to establish whether a CFD broker is reliable or not is regulation. If the broker is regulated by a trusted agency, that is usually a good sign. We then look at the user-friendliness of the interface, as well as fees, sign up process verification process and so on but that is something you can only test once you’ve signed up on it. A few things you can do research on beforehand are fees, asset variety and availability of payment methods. These are usually some good criteria to also base your decision on. I hope that helps.

  6. I’ve heard that CFDs constitute a major part of the trading industry but I am not sure I really get what CFD trading means. Can someone help?

    1. Hello Matt. Thank you for your question. The abbreviation refers to the trading of Contracts for difference, which allows you to speculate on the charges in price of the markets of currencies and commodities like indices, forex, treasuries and stocks. CFD trading can be done by means of a CFD broker meaning that, as the name suggests, this type of trading involves entering a contract with the broker.

    1. Hello Ron. Thank you for getting in touch. The best platform to trade CFDs is definitely eToro. The broker is regulated by most of the most trusted regulatory agencies out there, such as CySEC, ASIC and FCA and it is among the most well-reputed brokers available, with over 10 million active users currently trading on it. The sign up process is very simple and the verification process only takes a couple of days. Apart from that, the trading interface is very intuitive meaning that you will get familiar with it in a few minutes. Other than that, fees are very limited and the broker offers copy trading as a special feature. That means that you will be able to see and place the same investments placed by the top investors on eToro to improve your chances of making profits.

    1. Hello Silvie. Thank you for getting in touch. There is not really a minimum amount you need, but most of the CFD brokers out there require a minimum deposit amount, which can go as low as $10 to around $500 or more depending on the broker. The standard amount is around $250 and it is the amount required by one of our most recommended brokers, eToro. Other than that, you can invest as much money as you want on an asset, there are no restrictions.

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