How does CFD trading work

Lesson 1 of 4

What are contracts for difference (CFDs)

Speculating on the value of financial assets as they rise and fall has always been popular. Especially as there’s such a diverse range of markets to choose from, including:

  • Shares, like Apple or BP
  • Currencies, like the euro (EUR) or US dollar (USD)
  • Commodities, such as gold, oil or sugar
  • Stock indices that track the performance of a group of shares, such as the FTSE 100, or Nikkei 225
  • Other financial products such as interest rates and government bonds

At any one time, each of these assets is worth a certain amount of money. This is its price or market value, and it changes over time.

Today one share of Apple might be worth $113 but tomorrow its value may have risen to $115. Similarly, one euro could be worth around 90p this week, but in two months' time it might have dropped to 80p.

While buying and selling shares or exchanging currency may be relatively easy for an ordinary investor, buying commodities such as barrels of oil or taking a position on stock indices is far less simple.

A contract for difference (CFD) allows you to speculate on whether the value of any of these financial assets will rise or fall in the future, and is a far more accessible way to trade on markets such as commodities and indices.

When you trade a CFD you're not actually trading a physical asset. Instead you’re agreeing to exchange the difference in value of an asset between the point at which the contract is opened and when it is closed. This means that unlike traditional trading, CFDs enable you to speculate without taking ownership of the underlying asset. If you think the price of the asset will go up, you 'buy' (also known as going long). If you think it will fall, you 'sell' (go short).

Contracts for difference are derivatives, as the price of a CFD is derived from the value of an underlying asset. For example, you might open a CFD based on the price of gold, with the expectation the metal will rise in value. If the price of gold does indeed go up and you then close the contract, you’ll have the chance to profit. If it drops, you'll have made a loss.

Of course, the more the market moves in your favour, the more money you can make. And the further the market moves against you, the more your losses will stack up. Also, as you never own the physical asset, you can potentially profit from either rising or falling prices in the underlying market.

Lesson summary

  • A CFD is an agreement to exchange money according to the change in value of an underlying asset
  • It is a means to gain exposure to the change in value of a financial instrument without actually owning that instrument
  • Traders can take a long or short position on a CFD, potentially enabling them to profit from falling as well as rising prices
  • CFDs are traded in standardised contracts called lots, which differ in size for each asset
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