What is CFD trading and how does it work?

CFD trading is a popular way to speculate on rising and falling financial markets, including shares, forex, indices and commodities. And as CFDs (contracts for difference) are a derivative product – meaning you don’t own the underlying asset – you won’t pay stamp duty on any profits.*

Are you ready to start trading CFDs?

What is CFD trading and how does it work?

CFD trading is a popular way to speculate on rising and falling financial markets, including shares, forex, indices and commodities. And as CFDs (contracts for difference) are a derivative product – meaning you don’t own the underlying asset – you won’t pay stamp duty on any profits.*

Are you ready to start trading CFDs? Open an account today.

Call 0800 195 3100 or email newaccounts.uk@ig.com to talk about opening a trading account. We’re here 24 hours a day, from 8am Saturday to 10pm Friday.

Contact us: 0800 195 3100

What is CFD trading?

CFD trading is defined as ‘the buying and selling of CFDs’, with ‘CFD’ meaning ‘contract for difference’. CFDs are a derivative product because they enable you to speculate on financial markets such as shares, forex, indices and commodities without having to take ownership of the underlying assets.

When you trade a CFD, you are agreeing to exchange the difference in the price of an asset from the point at which the contract is opened to when it is closed. One of the main benefits of CFD trading is that you can speculate on price movements in either direction, with the profit or loss you make dependent on the extent to which your forecast is correct.

Main features of CFD trading

The main features of CFD trading, and uses of contracts for difference, are explained in the sections that follow:

What do ‘long’ and ‘short’ mean in CFD trading?

‘Long’ and ‘short’ in CFD trading are terms that refer to the position you take on a trade. With CFDs, you can speculate on market price movements in either direction – if you’re ‘long’ you believe that the price will go up, while if you’re ‘short’ you believe that the price will go down. So, while you can mimic a traditional trade that profits as a market rises in price, you can also open a CFD position that will profit as the underlying market decreases in price. This is referred to as selling or ‘going short’, as opposed to buying or ‘going long’.

If you think Apple shares are going to fall in price, for example, you could sell a share CFD on the company. You’ll still exchange the difference in price between when your position is opened and when it is closed, but will earn a profit if the shares drop in price and a loss if they increase in price.

With both long and short trades, profits and losses will be realised once the position is closed.

What is leverage in CFD trading?

Leverage in CFD trading is the means by which you can gain exposure to a large position without having to commit the full cost at the outset. Say you wanted to open a position equivalent to 500 Apple shares. With a standard trade, that would mean paying the full cost of the shares upfront. With a leveraged product like a contract for difference, on the other hand, you might only have to put up 20% of the cost. Learn more about the differences between CFDs and share dealing.

While leverage enables you to spread your capital further, it is important to keep in mind that your profit or loss will still be calculated on the full size of your position. In our example, that would be the difference in the price of 500 Apple shares from the point you opened the trade to the point you closed it. That means both profits and losses can be hugely magnified compared to your outlay, and that losses can exceed deposits. For this reason, it is important to pay attention to the leverage ratio and make sure that you are trading within your means.

What is ‘trading on margin’ with CFDs?

‘Trading on margin’ with CFDs is another way to describe leveraged trading. The amount of money required to open and maintain a leveraged position is called the ‘margin’ and it represents a fraction of the position’s total size.

When trading CFDs, there are two types of margin. A deposit margin is required to open a position, while a maintenance margin may be required if your trade gets close to incurring losses that the deposit margin – and any additional funds in your account – will not cover. If this happens, you may get a margin call from your provider asking you to top up the funds in your account. If you don’t add sufficient funds, the position may be closed and any losses incurred will be realised.

How can you hedge with CFDs?

You can hedge with CFDs by opening additional positions to protect against losses in an existing portfolio.

For example, if you believed that some ABC Limited shares in your portfolio could suffer a short-term dip in value as a result of a disappointing earnings report, you could offset some of the potential loss by going short on the market through a CFD trade. If you did decide to hedge your risk in this way, any drop in the value of the ABC Limited shares in your portfolio would be offset by a gain in your short CFD trade.

How do CFDs work?

Now you understand what contracts for difference are, it’s time to take a look at how they work. Here we explain four of the key concepts behind CFD trading: spreads, deal sizes, durations and profit/loss.

Spread and commission

CFD prices are quoted in two prices: the buy price and the sell price.

  • The sell price (or bid price) is the price at which you can open a short CFD
  • The buy price (or offer price) is the price at which you can open a long CFD

Sell prices will always be slightly lower than the current market price, and buy prices will be slightly higher. The difference between the two prices is referred to as the spread.

Most of the time, the cost to open a CFD position is covered in the spread: meaning that buy and sell prices will be adjusted to reflect the cost of making the trade.

The exception to this is our share CFDs, which are not charged via the spread. Instead, our buy and sell prices match the price of the underlying market and the charge for opening a share CFD position is commission-based. By using commission, the act of speculating on share prices with a CFD is closer to buying and selling shares in the market.

Deal size

CFDs are traded in standardised contracts (lots). The size of an individual contract varies depending on the underlying asset being traded, often mimicking how that asset is traded on the market.

Silver, for example, is traded on commodity exchanges in lots of 5000 troy ounces, and its equivalent contract for difference also has a value of 5000 troy ounces. For share CFDs, the contract size is usually representative of one share in the company you are trading. To open a position that mimics buying 500 shares of HSBC, you’d buy 500 HSBC CFD contracts.

This is another way in which CFD trading is more similar to traditional trading than other derivatives, such as spread bets or options.

Duration

Most CFD trades have no fixed expiry – unlike spread bets and options. Instead, a position is closed by placing a trade in the opposite direction to the one that opened it. A buy position of 500 gold contracts, for instance, would be closed by selling 500 gold contracts.

If you keep a daily CFD position open past the daily cut-off time (typically 10pm UK time, although this may vary for international markets), you’ll be charged an overnight funding charge. The cost reflects the cost of the capital your provider has in effect lent you in order to open a leveraged trade.

This isn’t always the case though, with the main exception being a forward contract. A forward contract has an expiry date at some point in the future, and has all overnight funding charges already included in the spread.

Profit and loss

To calculate the profit or loss earned from a CFD trade, you multiply the deal size of the position (total number of contracts) by the value of each contract (expressed per point of movement). You then multiply that figure by the difference in points between the price when you opened the contract and when you closed it.

Profit or loss
=
(no. of contracts x value of each contract)
x (closing price - opening price)

For a full calculation of the profit or loss from a trade, you’d also subtract any charges or fees you paid. These could be overnight funding charges, commission or guaranteed stop fees.

Say, for instance, that you buy 50 FTSE 100 contracts when the buy price is 7500.0. A single FTSE 100 contract is equal to a £10 per point, so for each point of upward movement you would make £500 and for each point of downward movement you would lose £500 (50 contracts multiplied by £10).

If you sell when the FTSE 100 is trading at 7505.0, your profit would be £2500

2500 = (50 x 10) x (7505.0 - 7500.0)

If you sell when the FTSE 100 is trading at 7497.0, your loss would be £1500

-1500 = (50 x 10) x (7497.0 - 7500.0)

Example: Lloyds CFD trade

Shares of Lloyds Banking Group Plc (LLOY) are currently trading with a buy price of 51.630 and a sell price of 51.600. But you anticipate that the stock is going to decrease in value over the next few days, so you decide to sell 150 share CFDs of LLOY at 51.600 – the equivalent of selling 150 shares of Lloyds.

Say Lloyds shares did fall in price and were trading at a new buy price of 50.000 and sell price of 49.970. You would close your position by reversing your initial trade, buying 150 share CFDs of LLOY at 50.000. To calculate your profit, you’d multiply the difference between the closing price and opening price of your trade by its size. In this case, your profit would be £240 ([51.600 - 50.000] x 150), excluding any additional costs.

Remember, unlike other CFD markets – which are charged via the spread – share CFDs are subject to a commission fee when you open and close the trade.

However, let’s say Lloyds shares had risen in price instead, up to a new buy price of 53.100 and sell price of 53.070. To close your position, you reverse the trade by buying 150 share CFDs back at 53.100. Your loss would be £225 ([53.100 – 51.600] x 150), again excluding any additional costs.

FAQs

What does CFD mean?

CFD stands for contract for difference, which is a derivative product that traders can use to speculate on the future direction of a market’s price. You’ll never take ownership of the underlying asset, which means you can take advantage of rising and falling markets.

Learn more about what CFD trading is.

How can I make money from CFD trading?

You can make money by correctly predicting whether a given market will rise or fall. When you trade CFDs, you are agreeing to exchange the difference in the price of an asset between when you open a position and when you close it. The more the asset’s price moves in the direction you’ve predicted, the more you would profit. But the more it moves against you, the more you would lose.

It is important to note that all trading involves risk. So, although you can make money from CFD trading, you should never risk more than you can afford to lose.

Learn how to start trading CFDs.

How can I get started trading CFDs?

To start trading CFDs, you’ll need to open and fund a CFD account. Next, you’ll need to choose which market you want to trade and do thorough analysis of the asset – this can be done through technical or fundamental analysis, depending on your personal preference.

When you’re ready to trade CFDs, you’ll just need to choose your position size and implement your risk management strategy.

Learn more about how to start trading CFDs.

How do IG and other CFD providers make money?

The main way CFD providers, such as IG, earn money is through the spread that is wrapped around the market price. The cost of trading is already factored into these two prices, called the offer and the bid, which means that you will always buy slightly higher than the market price and sell slightly below it.

Share CFDs are generally priced slightly differently from other CFD markets. With IG, we do not wrap our own spread on top of the market spread – instead, we take a small commission fee when you open and close the trade. Learn more about our charges.

Unlike some CFD providers, IG does not aim to profit if a client loses, as our business model is based on providing a fair experience to all traders. Learn more about how IG makes money.

How do I use CFDs for hedging?

The way to use CFDs for hedging is by opening a position that will become profitable if one of your other positions begins to incur a loss. An example of this would be taking out a short position on a market that tracks the price of an asset you own. Any drop in the value of your asset would then be offset by the profit from your CFD trade.

Say, for example, you hold a number of shares in Apple but believe these shares may fall in value in the future. You could go short on Apple via a share CFD. If you are correct and your Apple shares fall in value, then the profit from your short CFD trade will offset this loss.

How are CFDs taxed?

CFDs offer a number of tax benefits over other forms of trading. This is because they are exempt from stamp duty, and losses can be offset against profits for tax purposes.

Of course, it is important to keep in mind that tax laws are subject to change and depend on individual circumstances. Tax law may differ in a jurisdiction other than the UK.

What is the difference between CFDs and futures?

When you trade CFDs (contracts for difference), you buy a certain number of contracts on a market if you expect it to rise, and sell them if you expect it to fall. The change in the value of your position reflects movements in the underlying market. With CFDs, you can close your position any time when the market is open.

Futures, on the other hand, are contracts that require you to trade a financial instrument in the future. Unlike CFDs, they specify a fixed date and price for this transaction – which can involve taking physical ownership of the underlying asset on this date – and must be purchased via an exchange. The value of a futures contract depends as much on market sentiment about the future price of the asset as current movements in the underlying market.

It is worth keeping in mind that with an IG spread betting or CFD trading account, you can speculate on the price of futures contracts without having to buy the contracts themselves.

Does a CFD expire?

CFD positions do not have an expiry date on most markets, so can be held open for as long as choose to maintain your position. The only CFD markets that have an expiry date are futures and forwards, and options.

How long should you hold a CFD position open for?

There is no set rule for how long a CFD position should be held open for. Most CFDs have no fixed expiry date, so it will completely depend on the individual’s goals and circumstances.

However, many traders will only hold CFD positions open for a short amount of time as there are charges associated with holding most positions open overnight – excluding positions on options, futures and forwards – which can add up if you keep a position open for an extended period of time. Traders who avoid keeping positions open overnight are known as day traders.

Is CFD trading safe?

All trading involves risk, but if you create a risk management strategy you can at least minimise the risk that you take on. For example, attaching a stop-loss to your position will automatically close your trade if the market moves against you by a predetermined amount.

The best way to stay safe when CFD trading is to always use a trusted broker, and never risk more than you can afford to lose.

How can I trade forex with CFDs?

Trading forex with CFDs works in a similar way to trading via a forex broker – you are speculating on the price movements of currency pairs, without ever taking physical delivery of the currency itself.

When you trade forex CFDs, you can take advantage of leverage, which enables you to open a position by just paying a small proportion of the full position up front.

Learn how to trade forex.

Develop your knowledge of CFD trading with IG

Find out more about CFD trading and test yourself with IG Academy’s range of online courses.

You might be interested in…

Discover the differences between spread betting and CFD trading

Learn about risk management tools including stops and limits

Browser-based desktop trading and native apps for all devices

* Tax laws are subject to change and depend on individual circumstances. Tax law may differ in a jurisdiction other than the UK.

Spread bets and CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 75% of retail investor accounts lose money when trading spread bets and CFDs with this provider. You should consider whether you understand how spread bets and CFDs work, and whether you can afford to take the high risk of losing your money. Spread bets and CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage.