CFD Meaning and Trading Basics: A Starter Guide for Beginners
Dec 13 2024
Our CFD trading for beginners’ guide demystifies this popular form of derivative trading. We explain the CFD trading meaning compared with conventional exchange trading. We’ll also recommend some novice strategies to deploy when trading CFDs across any asset class for the first time.
What Is a CFD?
A contract for difference (CFD) is a type of financial derivative which can be traded via online brokerages. It gives retail traders the flexibility to speculate on the price movement of all kinds of underlying assets, since the contracts are tied to their market value.
When trading a CFD, you enter into a contract with a broker to exchange the difference in an asset’s price from the time they open the contract to the time it’s closed. Providing the price moves in your favor, you earn a profit when the contract is closed. If the price moves against you when the contract is closed, you’ll take a loss.
One of the biggest advantages of CFD trading is the freedom to trade assets in bullish and bearish markets. If you think an asset’s price is sure to rise, you would “go long” and take a buy position. If you think it’ll fall, you would “go short” and take a sell position.
CFDs give you the exposure to all kinds of assets without the need for taking physical ownership. This gives you great flexibility, but you must also apply strict risk management, especially since leverage can amplify gains and losses.
What Is a CFD in Forex?
Forex traders can also trade major, minor, and exotic forex pairs using CFDs. You can speculate on the price movements between currencies without having to own them.
Let’s run through an example of CFDs in forex trading by discussing how to trade the USD/ZAR CFD forex pair.
- The USD/ZAR pair is currently priced at 18.00, and you think the price can rise to 19.00.
- You’ll open a long (buy) position at 18.00, anticipating the U.S. dollar strengthening against the rand.
- As expected, the price of USD/ZAR rises to 18.50, and you can close out your position for a 0.50 profit.
- For every contract (which typically represents a lot size), this price movement translates into a profit using the lot size and leverage used.
How Does CFD Trading Work?
CFD trading allows you to speculate on market movements without owning any of the underlying assets you trade. There’s a series of steps to take from picking an asset to making a profit from the market:
- Handpick an asset
Your first mission is to decide which asset to trade. Ideally, you should pick an asset you’re knowledgeable about. It doesn’t matter whether it’s forex, equities, commodities or cryptocurrency. Every CFD available to trade is a reflection of the value of the underlying asset. - Open your position
Once you’ve chosen your CFD, you must decide whether to go long (buy) or short (sell). - Choose your position size and leverage
Decide how many CFD contracts you wish to trade. Most CFD brokers will offer leverage, which makes it possible to magnify the market value of your position using only a modest initial margin. For example, a leverage of 10:1 would mean for every €1 you deposit on margin, it would be worth €10 in market value. - Keep tabs on your position
Use your CFD broker’s supported trading platforms to monitor the real-time price of the asset you’re trading. Use their charts and technical indicators to try to gauge whether your entry position looks likely to be a profitable one. At this early stage, you should also have defined a stop-loss and a take-profit price point for your position, automating the process wherever possible. - Close your position for a profit or loss
If you believe your position is unlikely to reach your profit target, and you’d like to take a smaller loss, you can also manually close the position. Similarly, if you’d rather take a smaller loss than your maximum stop-loss, you can manually close it for a loss, too.
Let’s say that you believe the share price of Stock A will increase. You open a long (buy) CFD position at $50 per share for 50 contracts. Your CFD broker needs a 10% margin for a trade of this size, so you’d need to deposit $250 for an open position worth $2,500.
Within a month, Stock A’s share price has risen to $70. You decide to close your position for a profit. At $70 per share, you’re currently making a profit of $20 per share:
$20 x 50 CFD contracts = $1,000 profit
Advantages of CFD Trading
There are multiple benefits to becoming a CFD trader. Below, we’ll explore what CFD trading allows you to do in the financial markets:
- Access a global suite of assets within a single account
By opening a CFD trading account, you can open trades on all kinds of financial instruments across the global financial system. It could be stocks, bonds, commodities, forex or even cryptocurrencies. - Profit from long and short positions
With CFDs, it’s possible to make a profit by backing an asset’s value to fall as well as rise. Backing an asset’s value to fall is known as short selling or going short. It’s just as easy as buying an asset, you just take its sell price and close the trade by buying for a profit at a lower price. - No ownership of underlying assets
If you don’t want the hassle of having to physically own the assets you trade, CFDs could work perfectly for you. Since you don’t take ownership of assets, you’ll often avoid charges like stamp duty on equities or the cost of storage and delivery of commodities. - Cost-effective trading
CFD trading is a cheaper way of accessing the financial markets for many. With the right CFD broker, you can find competitive spreads and zero commission charged per trade. The lack of ownership of assets means you won’t be taxed on your profits, either. - An effective way to hedge investment portfolios
Many investors use CFDs as part of their hedging strategy. Hedging is a way of balancing the risks within their investment portfolios, offsetting potential losses with potential gains. You may retain a long position on a stock and open a short (sell) position on the CFD version of the stock to shield your portfolio during periods of volatility. - 24-hour market access
Pick the right CFD brokerage, and you’ll have 24-hour access to trade the global financial markets using CFDs, especially forex and cryptocurrencies. This gives you the flexibility to move fast and react to news and events as they happen, using fundamental analysis to frame your trading positions. - Real-time market exposure
With a CFD broker and their supported trading platforms you’ll get access to the real-time market prices, charts, indicators and analysis, just like a professional trader or a hedge fund manager. You can monitor live price movements and be proactive with your trading decisions rather than reactive and miss potential trading opportunities.
Risks of CFD Trading
It wouldn’t be a fair and comprehensive review of CFD trading without discussing the risks involved as well as the advantages. Below are some of the main risks associated with CFD trading for beginners:
- Overuse of leverage
With CFDs, brokers will usually offer leverage, allowing you to multiply the size of your open position with just a modest initial deposit. Although leverage can magnify potential returns, it can also hike potential losses too. If you over trade with leverage, you’re greatly increasing your risk of losing more of your trading bank. - Trading with a broker rather than a central exchange
When you trade CFDs, you trade them with a CFD broker instead of a central exchange. There’s always the risk of your chosen broker facing insolvency or encountering financial difficulties at the very least. If so, you may be at risk of losing your trading funds, especially if the broker is unregulated in the country you live. - Overnight and holding fees
Most CFD trading novices overlook the cost of paying overnight and holding fees to keep CFD positions open overnight. All of which can erode into your potential profits. - Hidden fee structures
It’s also possible for CFD brokerages to promote low fees or commissions but include hidden fees that make their platform uncompetitive overall. These include wider spreads between the buy and sell price, platform fees, or even increased financing rates. - Margin calls
If the value of an open CFD position – either long or short – goes against you significantly, it’s possible your broker may require you to deposit more funds to maintain your position. This is known as a ‘margin call’. If you don’t deposit the additional funds in time, your broker is within their rights to close out your position for an initial loss. - No formal ownership of assets
Some users may view derivative trading instruments like CFDs as attractive, enabling you to trade the price movement of the underlying assets. However, some may also see it as a negative, as you never own the underlying asset. If you trade CFD stocks, you won’t benefit from any shareholder dividends, for example.
How to Start CFD Trading as a Beginner
If you’d like to start trading CFDs and master the markets, you’ll need to follow these three simple steps:
- Step 1: Pick a reputable CFD broker
Start by choosing a reputable CFD broker. Seek brokers that are fully regulated and licensed in major financial authorities like South Africa’s Financial Sector Conduct Authority (FSCA).
Make sure you’re familiar with your chosen CFD broker’s fee structure, including their spreads, commissions, and overnight fees, as costs can impact your bottom line. It’s also good to pick a CFD broker which supports user-friendly trading platforms and essential trading tools. - Step 2: Open a demo account
Your first port of call should be to practice using the broker’s trading software without real money. If your chosen broker offers demo accounts, take up the opportunity to trade the CFD markets with demo funds. You can practice your strategies and watch how various assets move to understand market dynamics. - Step 3: Start small when you enter the real-money realm
Once you are familiar with the demo account, you can upgrade to a real-money account with the same broker. However, we highly recommend starting small. Deposit a modest amount – which you can afford to lose – and look to build up your trading bank over time using cautious risk management for every trade placed.
CFD Trading Strategies for Beginners
If you’re looking for some basic trading strategies you can deploy as a CFD novice, read on as we discuss some foundational approaches to consider from day one:
Trend Following
This CFD strategy requires you to speculate on the direction of an asset’s market trend. Use fundamental analysis (research and news reports), along with technical analysis (charts and trading indicators), to decide if the market is bullish (positive) or bearish (negative). Moving average indicators are effective in pinpointing short-term trends.
You must then open a CFD which aligns with your opinion of the market. If you think it’s entering a downtrend, you’d open a short (sell) position. If it’s entering an uptrend, you’d open a long (buy) position.
Range Trading
If a CFD asset is trading within a defined price range, it’s possible to buy and sell the asset between the bottom and the top of the trading range. The bottom of the range is known as the support level, with the top of the range known as the resistance level. It’s labelled resistance because the price begins to fall as there are more sellers than buyers.
If you trade short-term, range trading can be beneficial, but make sure you use careful risk management to guard yourself against potential breakouts from the current trading range.
Mastering Risk Management
Failing to plan is planning to fail. That’s the mantra most CFD traders apply. For every position you take, it’s important to have a clear strategy, detailing rules, goals, and risk limits.
Manage your risk by only committing a small percentage of your trading bank to a single CD trade. 1%-2% is normally the maximum risked per trade. This means that you’d have to suffer 50-100 losing trades in succession to lose your entire bank. You can define your maximum risk per trade using stop-loss orders, and your risk-reward ratio can also be set by take-profit orders.
You can also improve your bottom line by taking full advantage of the latest cashback bonuses offered by licensed CFD brokers.
Key Terms to Know in CFD Trading
The best way to navigate CFD trading effectively is to understand key terminology. Below, we’ll cover the most important definitions:
- Leverage
Leverage gives you the option to open larger positions with a small amount of capital. If a CFD broker offers 10:1 leverage, you’ll only need to deposit 10% of the full value of your position as margin. - Margin
Margin is closely linked to leverage. The margin is how much you need to deposit to open your leveraged position. Think of it as a security deposit to guard against potential losses amid unforeseen volatility. Margin calls are made by brokers, requesting you to deposit more money when positions start to move heavily against your entry position. - Spread
The spread is the gap between the bid (sell) price and the ask (buy) price of a CFD. The tighter the gap, the easier it is for your trades to move into profitability. Wider gaps are less welcomed, creating tougher trading conditions, especially for those trading over short timeframes. - Stop-Loss
A stop-loss order can be set to cut a losing trade for a predetermined loss. Using trading software, this order can be automated to happen as soon as the CFD’s price reaches that figure. It’s an important form of risk management. - Take-Profit
A take-profit order is another automated market order available using trading software. Essentially, it’s the opposite of a stop-loss – a defined price point where you’re happy to close your position for a guaranteed profit. - Long/Short Positions
“Going long” on a CFD means you’re buying the price of the CFD. “Going short” on a CFD means you’re selling the price of the CFD. The former requires the price to rise to profit, while the latter needs the price to fall to make money. - Contract Size
When you open any CFD trade, you’ll be asked about the contract size of your market order. The size stipulates the number of units controlled within a CFD trade. In forex trading, the typical contract size is 100,000 units of fiat currency.
CFD Trading FAQs
What is the CFD meaning?
A CFD stands for contract for difference. It’s a derivative product which acts as a contractual agreement between buyers and sellers of all kinds of financial instruments. Buyers pay the seller the difference between the asset’s current market value and its value at the time the contract was opened.
What is a CFD in comparison with the assets I trade?
A CFD is known as a derivative. It’s a contract which mimics the underlying market value of the asset. If the value of the underlying asset rises, so too does the value of the CFD. Put simply, it’s an opportunity to trade the price action of assets without having to physically own them.
Is CFD trading legal?
Trading CFDs is legal and well-regulated in many countries. It’s fully legal to trade CFDs in South Africa, with its Financial Sector Conduct Authority (FSCA) overseeing CFD trading and licensed CFD brokers. It's also legal in the UK, most of Europe and Australia. It’s worth noting that CFD trading is prohibited in the U.S. That’s because the US Securities and Exchange Commission considers it an over-the-counter instrument which doesn’t comply with US securities legislation.
Can I trade CFDs 24/7?
This depends on your CFD broker of choice. Some may offer 24-hour CFD trading, including weekend trading on specific markets. Others may offer 24/5 CFD trading hours, with no opportunity to trade out-of-hours on the weekend.