What is CFD trading and how does it work?

Think you’re ready for next-level trading? If you have a high risk appetite, consider CFD trading. To give you an overview, this article lets you know more about CFD — its meaning, its appeal and how it works.

What is CFD? Meaning and its basics

Contract for difference trading is a way of trading wherein you buy or sell a number of units for a particular instrument — whether it’s shares, commodities or currencies — based on your speculation of whether its price will go up or down. CFD is about price movements. Meaning, you don’t actually own the underlying asset. You enter into an agreement to exchange the difference in an asset’s price from when the contract is opened to when it is closed. This makes CFD trading a form of derivative trading.

In CFD trading, You can make or lose a profit depending on how your speculation matches the actual price movement. You can go long (buy) if you think the asset’s price will rise. On the other hand, you can go short if you think it will fall.

You can make the contract, typically, with a spread betting firm or an investment bank. It usually lasts just a few days or weeks. This differs from traditional investing, where you buy and hold onto your investments for longer.

What makes it appealing?

CFD trading is particularly appealing because it allows for leverage. In a nutshell, leverage lets traders like you hold a large position with a small amount of initial deposit. It means that you can gain full exposure to a trade without having to cover the total cost upfront. 

But as with any other type of trading, greater rewards come with a greater risk. Think of CFD trading more like gambling than investing. It’s because you’re speculating on price movements. And this very speculative nature makes it a favorite among forex and commodities traders who prefer betting on price movements rather than holding the underlying asset.

Another advantage of CFD trading is flexibility in terms of not being burdened by the drawbacks of direct ownership. Because you don’t own the asset, you’re not obligated to shoulder the costs of trading it as you would in trading.

Moreover, CFD trading closely mirrors the underlying market’s movements. This offers you a trading experience that closely reflects traditional market participation. 

Read: What is forex trading and how does it work?

How does CFD trading work?

If you want to trade without directly owning any asset — and you have a high appetite for risk — then CFD trading is for you. Here’s how it works.

Step 1: Opening an account

First, you must open an account with a broker that offers CFD trading. As this derivative trading is risky, it’s recommended to try it on a demo account first. Many reputable brokers offer demo accounts, which allow you to practice trading with virtual money. This way, you can develop strategies and get comfortable with them even before entering the actual market. 

Step 2: Choosing an instrument

As stated, CFD trading grants you access to a wide range of markets. These include currencies, commodities, stocks and indices. After you’ve opened an account, you will now choose a specific instrument or asset. But, instead of buying a specific amount of that asset, you will decide how many contracts you wish to trade (buy or sell) at the end of your contract period based on your market predictions.

Step 3: Trading positions

After you’ve picked an asset and how many contracts you’ll trade, it’s now time to actually do the trading. When entering a contract, you can take a long position (buy) if you think that the market price of the asset will rise. In contrast, you will take a short position (sell) if you anticipate that it will fall. You can earn or lose a profit depending on the difference in prices from when you open your position to when you close it. Your net profit or loss will also take into account any fees or costs that the broker charges.

Tips when trading CFDs

Want to make your CFD trading journey more lucrative? Here are some tips to help you achieve this goal.

• Understand risks and returns. Know that your potential return in CFD trading is linked to the size of your position and the actual movement of the market. You can incur losses if the market moves against your position, potentially exceeding your initial investment. Recognizing this risk, you must determine how much you’re willing to invest and how much you can afford to lose. 
• Trade on the right platform. You must only engage with reputable trading platforms when doing CFD or any type of trading. You must also take advantage of the tools, indicators and charts they offer to help arrive at informed decisions. Most reputable brokers also offer mobile apps for easier monitoring and trade management. 
• Know the market. Each instrument or asset’s market has different dynamics. Whether you’re considering a long or short position, the key is knowing the specifics of the market you’re entering. Apart from tools provided by your broker, do your own homework and stay tuned to market-related news, trends and developments. All these are essential in crafting a robust trading strategy.

Final thoughts

CFD trading is based on the difference in prices of a certain asset between the opening and closing of a trade. Harnessing your speculation prowess, it can lead to profits that far exceed your initial deposit. Nonetheless, the risk is equally high. Meaning, your losses can also substantially surpass your initial investment if the market moves against you. 

You must take a disciplined approach to navigate this high-risk-high-reward kind of trading. Research the market thoroughly, know risk management and invest only what you can afford to lose. 

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