What is CFD trading?

CFD trading enables you to buy and sell forex, shares, indices and more from a single account.

What are CFDs?

CFDs are a type of financial derivative that enable you to go long and short on thousands of different markets without ever taking ownership of any physical assets. CFD stands for contract for difference.

Instead of buying and selling the underlying asset, you speculate on its price movement. This means you can speculate on a host of different assets, from shares to indices to commodities and more, without needing to open accounts with lots of different brokers.

How does CFD trading work?

CFD trading works using contracts that mirror the prices of financial markets, such as a share, index or currency pair.

When you open a CFD trade, you agree to exchange the difference in the price from when you open your position to when you close it. Hence the name – contracts for difference.

• When you buy a CFD, you will make a profit as the market rises in price. But you will make a loss if the price falls
• When you sell a CFD, you will make a profit as the market's price falls. But upwards movement will lead to a loss

The number of CFDs you buy or sell dictates the size of your position. Buying a single Apple CFD, for example, is the equivalent of investing in one Apple share. Buying 1000 Apple CFDs, meanwhile, is the same as purchasing 1000 Apple shares.

To close a CFD trade, you trade in the opposite direction to when you opened it. If you bought a single Apple CFD at the outset, you'd sell a single Apple CFD to exit.

CFD trading examples

1. Buying oil

1. You buy US oil CFDs at 5325 when oil is at 5324/5325. Each CFD will earn you $1 for every point that oil moves up in price
2. US oil rises 30 points to 5355/5356, so you sell five oil CFDs at 5355 to close

Closing a CFD trade means that you exchange the difference in the asset's price from when you opened it. The market has moved 30 points in your favour, so you make (30 x 5 CFDs) $150.

However, if oil had moved 30 points against you, you would have to pay $150.

2. Selling the US 500

1. The US 500 is at 2340/2341. You short the US 500 by selling five CFDs at 2340
2. The US 500 falls to 2274/2275. You close your trade by buying five CFDs at 2275

The market has moved 65 points in your favour – so your five CFDs earn you (65 x 5) $325. However, if the US 500 had climbed instead of falling, you would have made a loss.

Benefits of CFDs

Range of markets

CFD providers typically offer access to lots of different assets. With FOREX.com, for example, you can buy and sell all of the following from just one account:

• 80+ FX pairs, from majors such as EUR/USD to exotics such as CHF/HUF
• The world's leading indices, including the UK 100, Wall Street, US SP 500 and more
• Apple, Barclays, Tesla and thousands more global shares
• Commodities such as gold, oil and silver

This makes CFDs an excellent way to diversify your exposure. If you're concerned about a global stock market slowdown, for example, you can use CFDs to trade commodities or forex. In doing so, you won't be so dependent on stocks to generate returns.

Going short

As we covered in the previous lesson, going short with a stockbroker can be a tricky process – if your broker even allows it. Opening a short position with a CFD, though, is essentially just the opposite of going long.

This can make CFDs popular for hedging. Some investors use CFDs to avoid having to sell an asset that they believe is in for a temporary downturn. For example, if you hold £5000 of Vodafone shares and are concerned that they are due for an imminent sell-off, you can help protect your share portfolio by shorting £5000 of Vodafone CFDs.

If Vodafone's share price falls, the loss in your portfolio would be offset by a gain in your short sell CFD trade. In this way, you can protect yourself without going through the expense and inconvenience of liquidating your stock holdings.

Leverage

CFD trading is a leveraged product, so you only need to put down a fraction of the total value of each contract to trade.

In other words, you can put up a small amount of money to control a much larger amount, which makes CFDs popular among investors who don't want to tie up lots of capital on each position. When trading a Barclays CFD, for example, you might only have to pay 20% of the value of Barclays shares. The deposit you pay is called your margin.

It's important to note that margin will magnify your profits and losses from a trade, however. So while it can lead to higher returns, it will also increase your risk.

Tax efficiency

CFD trading enables you to speculate on the price movements of assets without actually owning them. Because of this, you don't have to pay UK stamp duty on CFD trades – which would be required if you were investing in the assets themselves.

Remember, though, that UK tax laws are subject to change and depend on individual circumstances.

Is CFD trading right for me?

CFDs are ideal for people who are looking to either invest, speculate or hedge using leverage. However, they contain significant risks to your money and are not suitable for everyone.

CFD trading may be ideal for people who are:

• Looking for short-term opportunities
  CFDs can be held open for a few days or weeks, as well as over the longer term
• Who want to make their own decisions on what to invest in
  Most CFD providers offer an execution-only service
• Looking to diversify their portfolio
  FOREX.com offers access to hundreds of global markets including shares, commodities, FX and indices