How does CFD trading work
Why trade CFDs?
We’ve looked at what CFD trading is and how it works, but you may be wondering about the advantages of opening a CFD position rather than trading in the more traditional way. Let’s take a look at the reasons to choose CFDs.
Capitalising on falling markets
In traditional trading, you normally buy an asset in the hope its value will rise, so you can sell for a profit. However, with CFDs you can equally well take a view on an asset you expect will fall in value – known as going short.
As you’re simply taking a position on the direction you think a price will take, you can keep dealing even in bearish markets.
Thousands of markets
With traditional trading, you might have to use separate brokers specialising in different asset types, such as shares or foreign exchange. However, most CFD providers offer a diverse range of global financial markets, all together on a single platform.
With CFDs you can also trade on markets that are difficult to access in other ways. Stock indices, for example, can’t be bought or sold directly, but you can use CFDs to trade on their movements.
Most markets have set dealing hours. The FTSE 100, for example, is only open from 8am to 4.30pm in the underlying market. Ordinarily, after it closes for the night, you’d have to wait until the following morning before you can deal.
You may, however, find that some CFD providers allow you to deal round-the-clock on certain markets. This means that, even if the market you’re betting on is shut, you can still open and close your positions.
With conventional trading you generally need to pay the full purchase price of an asset up front. CFDs, however, are a leveraged product. So when you place a CFD trade your provider will ask you to put up a sum representing just a fraction of the total value of the position.
Leverage gives you a relatively large exposure to a market with just a small deposit.
Imagine you wanted to trade CFDs on gold:
- Without leverage, buying one ounce of gold might cost £800
- But your CFD provider only charges an initial deposit margin of 5%
- This means you need to put down a deposit of just £40 to open a position on an ounce of gold
IncorrectWhen you trade shares without leverage, you have to put down their full value. In this case that's £5 x 200 = £1000.
IncorrectThe upfront cost of this trade is 5% x £1000 = £50.
The risks of using leverage
Leverage can work to your advantage when you trade CFDs, however it’s important to remember that both profits and losses are based on the full size of your deal.
This means they could far outweigh the size of your initial deposit. So leverage is a benefit of CFDs, but also its biggest risk.
Did you know?
When trading on margin, a minimum margin level must be maintained on open positions at all times. Providers typically calculate the profit, loss and margin requirement constantly in real time and display it for their clients on screen. If the amount of money deposited drops below the minimum margin level, providers will ask for more money to cover the positions (known as a margin call), and may even close them if the losses get too large.
You can look at leverage in more detail in the orders, execution and leverage course.
- CFDs give you access to thousands of markets in one place
- You can trade CFDs 24 hours a day on some markets, eg forex and major stock indices
- CFDs are leveraged product so you don’t have to put up the full value of your position. As such, both your profits and losses may be magnified in relation to your initial deposit
- If the money held on your account drops below the level needed to cover your positions, you'll receive a margin call