What are CFDs?

Contracts for Difference, also know as “CFDs” or “CFD trading”, are a class of financial instruments known as “derivatives”. In other words, they are markets that are based on underlying assets, but you do not own the assets themselves.

Contracts for difference are so-called, because they form a contract between two parties (typically described as “buyer” and “seller”) on the movement of the underlying asset price. When you trade a CFD, you are agreeing to exchange the difference in the price of an asset from the moment the contract is opened, to the moment it is closed.

CFDs can be based on the following underlying markets:

– Indices
– Stocks & Shares
– Currencies
– Commodities (e.g. precious metals and energy)

CFD trading allows you to trade a position based on the price of an instrument, without actually owning the underlying asset. CFDs also allow you to profit from falling markets as well as rising ones. This allows you to profit from falling markets where it is not normally possible to do so if you do not own or borrow the underlying asset.

CFDs are traded using margin and leverage, therefore gains (and losses) can be amplified to a greater extent than buying the shares themselves, and with much less capital required.

CFDs are subject to the usual tax on capital gains, but are exempt from stamp duty – even when the underlying asset is a UK security.

For example, if you wanted to purchase 100 shares of HSBC Holdings PLC (HSBA) and the share price is £380 (this would typically be quoted as 380.00p), the total required investment capital would be £38,000. For this, you will receive share certificates and documents certifying your ownership of the shares. You have physical, legal proof of ownership when it is time to sell your shares, ideally for a profit.

With CFDs, however, you don’t own the HSBC shares. You are, instead, speculating, and potentially profiting, from the same movements in share price as if you owned the real shares, and you are able to manage your position online.

Leverage in CFD Trading

Leverage allows you to control much larger positions in the market with smaller initial deposits. In turn, the potential profits from your investments are significantly larger than in other forms of trading.

Looking at the example of HSBC shares above: The 100 shares of HSBC are priced at £380, costing you £38,000 as a gross cost, without including brokerage fees or commissions.

When trading CFDs, however, you only need a small percentage of the total trade value to open the position and maintain the same level of exposure. Assuming 5:1 (20%) leverage on HSBC shares, this means you would only need to deposit an initial £7,600 to trade the same volume.

If HSBC shares rise 10% to £418, the value of the position is now £41,800. So with an initial deposit of just £7,600, the CFD trade has made a profit of £3,800

However, if HSBC shares fell 10% to £342, the value of the position would be £34,200. So with an initial deposit of just £7,600, this particular CFD trade would make a loss of £3,800.

Whilst leverage can increase your profits, losses are also larger as well. If price moves against you, you could be closed out of your position by a margin call or have to add more funds to your account to keep your position open. We will cover risk management in later chapters of this course.

CFD Trading Terminology

We will now look at some important terminology and concepts in regard to CFD trading. These include:

– Spreads & Commissions
– Position Sizing
– Trade Duration

Spreads & Commissions

CFDs are quoted in two prices: the buy price (“ask”) and the sell price (“bid”), and allow you to profit from both rising and falling prices. We will examine the bid/ask in more detail in this course.

– If you believe the price of an asset is going to rise, you go long or ‘buy’.
– If you believe the price of an asset is going to fall, you go short or ‘sell’.

If the instrument you are trading moves in the direction you are trading in, you will make a profit.

If the instrument you are trading doesn’t move in the direction you are trading in, you will suffer a loss.

So, if you believe, for example, that the FTSE100  index price will fall in value, you go short on the FTSE100 CFD and your profits will rise in line with any fall in price below the price at the start of the trade. However, should the FTSE100 price rise, you would suffer a loss for every price movement to the upside. Your profit or loss will depend on position size (lot size) and the number of points the market moves.

Position Sizing

Trading CFDs has more in common with traditional trading products – such as Forex or Futures – than other derivatives such as Options trading. This is largely due to the fact that CFDs are traded in standardised contracts, or lots. The size of an individual lot depends on the underlying asset being traded and often reflects the same pricing characteristics of the underlying market.

N.B. It is important to note that the position sizes for Forex and CFDs based on one standard lot can be very different, as shown in the table below:

Trade Duration

Most CFD trades have no fixed expiry, however you should check with your broker to ensure this is the case. Positions could theoretically be held indefinitely. Positions, in theory, are closed by placing a trade in the opposite direction to the opened position, although in practice trades are ended when they hit the take profit level, the stop loss level or are closed manually in the MT4 terminal.