How to Trade CFDs

If you’re interested in learning trading contracts for differences (CFDs) but don't know where to start, you've come to the right place. This comprehensive guide will walk you through everything you need to know about CFD trading, from understanding how CFDs work to executing your first trade. 

By the end of this article, you will have a solid foundation in CFD markets and trading and be ready to take the next step to becoming a successful CFD trader.

How CFD Trading Works

Before you dive into the specifics of how to trade CFDs, it will help to first establish a clear understanding of what CFDs are and how they function. CFD are financial derivatives that allow traders to speculate on the rising or falling prices of various assets, including currencies, commodities, indices and shares, without actually owning the underlying asset. 

Essentially, CFDs enable traders to gain exposure to a diverse range of markets with greater flexibility and efficiency than traditional investing methods. When trading CFDs, you enter into a contract with a broker to exchange the difference in value between the entry and exit points of your chosen asset. 

When trading CFDs you will need to pay away the dealing spread to the market maker you transact with. This two-way price consists of the sell price, also referred to as the “bid” and the buy price, also known as the “ask” or “offer.” These two prices encapsulate the current market sentiment regarding the value of the underlying asset. 

When you open a CFD trade, you either take a long position, in which you buy first and sell later, or a short position, where you sell first to buy it back at a later time. Essentially, you are betting on whether the price will move higher or lower relative to the point at which you entered the market. If the market moves in your favor, you will earn a profit. Conversely, if the market moves against you, you will incur a loss.

Now that you understand the basics of CFD trading, it is time to explore the practical steps involved in getting started trading CFDs.

Steps for How to Trade CFDs

Entering the world of CFD trading can appear daunting initially, but breaking down the process into actionable steps simplifies matters. To get started with CFD trading, there are five essential stages you must navigate that are described below. 

1. Open a CFD Account

To begin trading CFDs, you must first find a reputable broker that supports CFD trading, although regulatory restrictions may prohibit U.S.-based  traders from opening a CFD account. Carefully evaluate potential CFD brokers based on their reputation, fees, supported markets and customer service before making a decision. Once you have selected a suitable broker to trade through, you will need to visit their website and follow their registration process to create and fund your new CFD trading account.

2. Pick a CFD Market

With your CFD account now set up and funded, you will need to select which market(s) to trade in. Popular options for tradable assets include currencies, futures, stocks and commodities. Each market comes with unique advantages and disadvantages, so research them thoroughly and assess your personal preferences, expertise and risk tolerance before diving into CFD trading.

3. Choose How to Buy Contracts

Before placing a trade, familiarize yourself with the basic principles governing CFD contract sizes. In essence, each contract corresponds to a predetermined quantity of the underlying asset. 

For stock CFDs, for example, one contract might correspond to one stock share. Also keep in mind that every time you initiate a trade, you will be selling at the bid side of the market and buying at the offer side. 

The difference between these values constitutes the dealing spread, which represents the cost charged by the market maker for facilitating the CFD trade, in addition to any commissions your broker might charge. 

When it comes to positioning, if you believe the CFD market will go up, you will want to go long by trading at the offer price, while if you think the market will decline, you will want to go short by trading at the bid price.

4. Set Up and Execute Your Trade

Now that you grasp the fundamental concepts behind buying CFD contracts, it is time to examine the mechanics of setting up and executing trades. First, you must specify the desired position size that is measured in terms of the number of contracts you intend to purchase or sell. 

Next, you must allocate sufficient margin from your trading account as collateral to support your trade. Finally, you can use stop-loss and take-profit orders to safeguard your trade and lock in profits. 

After completing these steps, you can simply click “Buy” or “Sell” in your chosen broker’s online trading platform to submit your CFD order. Once executed, your trade confirmation should display all the details of the completed transaction.  

Position Sizing

Position sizing is an important aspect of money management that you will need to incorporate into your CFD trading plan, and various position sizing techniques exist. For example, many CFD traders prefer to determine their position sizes according to the size of their trading accounts. You will also want to adjust your position sizing methodology carefully to match your risk appetite and capital resources.

When sizing your positions, remember that each contract equates to a fixed quantity of the underlying asset but that contract sizes can vary depending on the underlying asset. For instance, a stock CFD will typically correspond to a single share, but CFDs on other assets like forex currency pairs will involve trading in lot sizes equivalent to thousands of units of the base currency. 

Margin

You will also want to get acquainted with the notion of margin in trading, which refers to the collateral deposited in your trading account used to secure your broker against your potential losses on a given CFD trade. Brokers often express margin requirements as a percentage of the overall trade value, and they can range anywhere from 0.5% to 2%, depending on factors like the instrument type, volatility and prevailing market conditions. 

Ensure that you have ample funding in your trading account to meet necessary margin obligations, especially if trading with leverage. Also, remain aware of the distinction between initial and maintenance margins. Initial margin is what you need to put up when you first take a trade, while maintenance margin must be deposited if your losses exhaust the initial margin. Keep in mind that your failure to maintain adequate margin levels in your trading account could result in a forced trade closure being initiated by your broker.

Using Stop and Limit Orders

Most traders prefer to use stop-loss and limit orders strategically to protect their CFD positions and maximize their trading returns. Whether going long or going short CFDs, a stop-loss order will automatically terminate a losing position when the market reaches a specified threshold value, thereby limiting your potential loss to a tolerable level. In contrast, limit orders help you take profits and lock in your trading gains by closing winning trades out at preset profit targets. Appropriately setting your stop-loss and take-profit levels is a key part of risk management that promotes disciplined trading practices.

5. Monitor Your CFD Trade

Once you have initiated a CFD trade, you will need to regularly track market movements and adjust your trading positions accordingly using the desktop, web or mobile platforms provided by your broker. Be prepared to react swiftly when desirable trading opportunities arise to ensure the timely entrance and exits of CFD trades whenever your trading plan dictates a transaction should be made.

CFD Trading Examples

You can now apply your newly acquired knowledge about CFDs to a realistic scenario involving trading CFDs on the GBP/USD currency pair. Suppose the current exchange rate offer hovers around 1.2143, while the bid rate is 1.214. 

If your market analysis indicates that the British pound might strengthen soon, you will probably want to take a long position in the pair. You decide to do this by buying a mini lot CFD with a notional amount of £10,000 at the offer rate of 1.2143 after checking that your account can afford sufficient margin based on your broker's guidelines. 

Over subsequent days, the GBP appreciates, pushing the pair’s exchange rate upward until the bid rate reaches 1.22. At this point, you can seize the opportunity to realize your unrealized profits and close the CFD trade, yielding a return of 57 pips or $57.

Benefits and Risks of Trading CFDs

As with any form of trading or investment, engaging in CFD transactions carries the potential for both rewards and losses. Below Benzinga lists some critical pros and cons worth considering before venturing into trading CFD markets in a live account.

Benefits

• Accessibility: Trade numerous global markets using a single trading platform with many CFD providers.
• Leverage: Amplify your position sizes by trading on margin with online brokers.
• Short selling: Capitalize on declining markets without requiring physical asset ownership.
• Many instruments: Speculate on a diverse range of underlying assets, including stock indices, commodities, shares and currency pairs.
• Hedging capabilities: Mitigate your downside risks by counterbalancing existing positions and portfolios with CFD positions.

Risks

• Risk concentration: Exposure to substantial financial losses can result from adverse market fluctuations, especially if high leverage levels are used. 
• Limited regulation: CFD markets generally operate over-the-counter, so they are not well regulated compared to centralized exchanges. 
• Not available in all jurisdictions: In the U.S., CFDs have been banned for retail traders by the Securities and Exchange Commission (SEC). CFD trading is also banned in Belgium and Hong Kong, while other countries like Austria, Cyprus, France and Australia have implemented strict CFD regulations.  
• Complex products: Mastery of CFD trading generally requires proficiency across multiple domains such as technical and fundamental analysis, risk assessment and money management.
• Overnight financing fees: You may need to pay rollover interest rates for maintaining positions overnight.
• Slippage and gap risk: These execution quality concerns can arise in volatile trading environments.

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Is CFD Trading for You?

Having explored the fundamentals of CFD trading and grasped its core mechanisms, the ultimate question will remain: Is CFD trading an ideal fit for you? If CFDs are available in your jurisdiction, then trading them can bring considerable financial rewards if you're willing to invest the risk capital as well as the time, effort and resources to hone the needed skills

Of course, these instruments can also present considerable challenges and risks, so you will need to develop and test a sensible trading plan to guide your CFD trading activities. You can start the process of deciding whether trading CFDs makes sense for you by evaluating your finances, goals, personality and experience to see whether they align with the demands of CFD trading. 

Keep in mind that cultivating success as a trader in any financial market generally takes patience and determination, so approach CFD trading wisely armed with foresight, restraint and a commitment to your ongoing education. With the proper attitude, CFD trading can become a viable income source.

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