What are CFDs? - how do they work

06 March 2020

CFDs, also known as Contracts for Difference are instruments that allow people to trade assets without having to own them. But what are CFDs in trading and how do they work? Do they offer better options to traders than regular instruments do? Well, in some cases yes and some cases no.

A CFD can be traded for every financial instrument. It can be for stocks, currencies, commodities, and indices as well. The CFD simply gives the trader the opportunity to speculate on the price changes of an asset, without having to actually buy it.

A trader simply makes a prediction of whether the price is going to increase or decrease. If the market changes exactly how the trader predicted, then he or she will find payout. However, if it goes the other way, the trader could face a lot larger losses than he or she would with regular instruments.

The real meaning in what CFDs are is in the diversity it has for the trader. Without them, most would have to find brokers for all of the assets they’d like to trade. With CFDs though, one platform is usually enough to trade pretty much everything one can imagine. It’s one of the main reasons why people go for CFDs in the first place, but there are many others as well.

How do CFDs work?

CFDs work pretty much exactly how any other asset works. A trader simply places a trade on the market based on what he or she had researched and then waits for the results. One important difference is what CFD traders actually call “buying” and “selling".
What are CFDs in trading

They refer to them as “long” and “short”, but the names don’t necessarily have any meaning in them. They’re just words.
The most unique answer to how does a CFD work is that it’s an instrument that can help people make payouts even when the market is going down. That’s right, if the trader had predicted that the market was going to go down and made a “short” trade, he or she will still find some payout.

Advantages of CFDs

There are so many advantages to talk about for CFDs, so let’s try and make a list before we begin:

Payouts from decreasing markets
Margin trading on stocks and commodities
Variety of assets

Now let’s try and break all of these down one by one.

Decreasing markets - as already mentioned before, one of the biggest advantages of CFDs is that traders have a unique opportunity to make payouts even when the market is going down. All they have to do is simply “register” their prediction in the system, and if it turns out to be true, they make a payout. Such trades are impossible in regular Forex or stock markets.

Margin trading - margin trading is not necessarily considered an advantage for beginner traders, but it is very important for expert traders. It basically allows a person to buy or sell much more than they have available on their account. Let us try and bring an example of how does CFD trading work with margin.

Imagine that a company’s stock is worth $10, so you buy 1000 CFDs because you believe the price is going to increase very soon. However, you soon find out that the margin rate for this company is 10%, so you only need to deposit 10% of your trade size. 10x1000=10,000 which is the actual amount you were supposed to deposit. But thanks to the margin rate, you need to deposit only $1000 now.
Let’s say your prediction was correct and the company’s stock is now at $15. That immediately puts your trade size to $15,000. Take away the $9000 that was given to you by the broker and you are left with a $6,000 payout. This would be very hard to do without margin.

Variety - when it comes to variety, it’s safe to say that CFD traders have hit the jackpot. No matter what instrument they want to trade, it’s available right in front of them, if the broker supports it.
Almost every single financial asset can be traded through CFDs, which makes diversifying your portfolio quite easy.
In a sense, it is considered to be the best way to diversify a portfolio by some traders. You are not only trading different assets, but you are trading in completely different markets. So the effects are different as well. If FX is doing terribly, people simply switch to stocks or commodities.

Disadvantages of CFDs

Although there are more than enough advantages, there is an equal number of disadvantages with CFDs as well.

Deadlines
Can’t have long-term positions
Leverage risk

Let’s try and explain all of them one by one as well.

Deadlines - these are sometimes referred to as the biggest problem that CFDs have. You see, every position a trader opens needs to have some kind of deadline given to it. These are usually a week, but there have been cases when people were given only 24 hours to close their trades.
If the trader fails to close their trade before the deadline, it will be automatically closed no matter if it is in a good or bad position. The only way to postpone the deadline is to pay a fee, which can sometimes be quite a lot. Considering that there are a lot more fees associated with CFDs, it can sometimes get very expensive.

Long-term positions - another big disadvantage of CFDs is that traders cannot open long-term positions. Well, you still can, but it would require postponing the deadline over and over again. That can get so expensive that by the time you’re ready to close the trade, you’ve already spent the exact amount you were supposed to get as a payout. So your total payout would be zero. Considering how some assets take a long time to grow a lot, this could become a problem for traders down the line.

Leverage risk - Sure we first mentioned leverage or margin trading as an advantage, but it also has its dark side as well. You see, a leveraged CFD trade may bring quite a lot in payouts if it is successful, but if it is not, then it will make the trader lose much more than they would have without the leverage. This is one of the biggest CFD trading risks that hold traders back. Most traders simply don’t use the leverage at all; but at that point CFDs pretty much lose all of their value too.

What are CFDs in trading - Key takeaways

CFDs or Contracts for Differences are instruments that help with trading other instruments. Nobody has to own any stocks, indices or commodities if they are trading them through CFDs.

CFDs can sometimes bring a very positive boost to your account thanks to the margin trading opportunity. However, if the payouts are twice as big with leverage, the losses are 5 times as big. So it’s always important to be careful with the CFD trading risks and issues.

CFDs are designed for “fast traders”, basically people who like to close trades as fast as they open them. It’s very hard to hold a long-term position with CFDs because they are restricted by deadlines. Increasing these deadlines requires fees, which can get pretty expensive.

FAQ on CFD trading

What is CFD trading and how does it work?

A direct CFDs meaning is Contracts for Difference, and this type of trading asset has become pretty popular in financial markets, whether it's Forex, stocks, or commodities. Here is how CFD works in these markets:

If you are a Forex CFD trader, it is not the actual currencies like the USD, EUR, or JPY that you are buying, rather the contracts that have those currencies as underlying assets. And the fundamental trading principle remains the same: Forex CFD trading means that you are buying/selling a certain contract at a given price, then wait for the price to increase/decrease, and once it reaches a preferred level for you, sell/buy it.

When it comes to what is CFD trading in commodities, its benefits are quite a bit more apparent. Let's take a look at the gold CFD meaning: instead of physically buying and then selling this asset, which is associated with a lot of logistical issues, with CFDs, you're just trading a contract that doesn't take any physical space.

Another great benefit of how does CFD work is the fact that you don't need to own an asset firsthand to then sell it; a contract allows you to open a short position for an underlying commodity just as easily as opening a long position.

What can be traded through CFDs?

As long as it is called a financial instrument, it can be traded through CFDs. This includes things such as stocks, commodities, indices, currencies, bonds, and pretty much anything else.

This is considered to be the biggest advantage of CFDs. If it turns out that the currency market is not doing too well, CFD traders can quickly switch to stocks, and then to commodities if necessary. It’s a good way to diversify the portfolio.

How does leverage work for CFDs?

Leverage is probably the most important part of CFDs. It can be said that the whole idea of how CFDs work lies within leverage itself.

When opening a trade, a person can include leverage, which means that your trade is going to grow in size. This could mean bigger payouts or much bigger losses. It’s usually not recommended for beginners to use unless they’re absolutely sure they know what they are doing.

Most CFD instruments have fixed leverage ratings. For example:

FX - up to 1:1000
Stocks - around 1:50
Commodities - around 1:50

Can I lower the leverage?

Yes. Most brokers mention the maximum leverage they have available, which means that you can lower it whenever you want, or disable it completely to lower your risk when trading CFDs. If you are a beginner, most people would suggest disabling it in the beginning before you learn how it works and why it is even included in your software.

Are CFDs better than regular assets?

Yes and no. CFDs have quite a lot of advantages over regular assets, but they also have disadvantages. For example, you can trade stocks on margin which can bring quite a lot of payouts, but you can’t hold a single position for too long because there are deadlines. Postponing those deadlines can get very expensive.

Is CFD trading safe?

No. Much like any other trading method, CFD trading is very risky and requires just as much research as FX trading or stock trading would. Although CFDs can potentially bring a lot in payouts, they can potentially bring much more in losses as well. And considering how the financial market works, a loss is much more likely.

Where can I trade CFDs?

CFDs are usually traded with CFD brokers, but there are a lot of cases where Forex brokers have started offering CFD trades as well. In most cases, the brokers have a whole collection of instruments to trade through CFDs, but there are exceptions where a broker may target only one instrument.

How long can I trade CFDs?

About a week or a couple of days. Every trade is based on a futures contract, which has a CFD deadline. If you do not close your trade before the deadline, the system will do it for you. Sure you can pay a fee to extend the deadline, but as already mentioned in the guide, that could prove to be very expensive if done often. A common strategy for CFD traders is to predict very small changes in the market and open leveraged positions that they can close very fast.

What are CFD benefits that I should choose them for?

What is a CFD? It's a contract that enables you to trade just about any spot instrument with more convenience. Among many benefits of CFDs explained, the most useful one is definitely the ability to exchange an asset that doesn't have any physical dimensions.

For example, there are much less logistical difficulties when trading oil CFDs meaning you don't need to buy spot oil in its physical form. Besides, CFDs also enable to you open both buy (long) and sell (short) positions in the market, whereas with physical assets, you first need to buy them and then sell in the market.

So, what is CFD benefit? Convenience, yet it's not the only one: you can also use much higher leverage rates with CFDs. For Forex pairs, leverage can go as high as 1:1000 or even more, whereas spot assets are more limited in this sense.