Introduction to CFDs (Contracts for Difference)

Welcome to the first in a series of articles on Financial Expert about Contracts for Difference, known as CFDs. In this introduction to CFDs, we’ll begin from the start – explaining what a CFD is and why you might want to use them to trade the financial markets.

CFDs offer a way to trade the financial markets with the flexibility and speed that the modern online trader needs. If you have been looking for a platform that will allow you to make calls on the intra-day direction of a wide range of securities and commodities, you’ll be very interested in following our CFD guide as these trading products may be suitable for you.

We will cover the risks of CFDs in its own separate article, but for balance, we would like to explain that spread bets and CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage.

This article is only intended as an introduction to CFDs, so we only cover each element briefly and do not dwell too much on each subject. If you’re interested in reading more, follow the links in the article or visit our other CFD articles in this series for greater depth.

An introduction to CFDs

What are CFDs?

CFDs stand for ‘Contracts for Difference’ and are a type of trade that a trader can enter into with a CFD provider. It is a one-way bet on the price movement of a particular security, such as a share, bond, commodity or even an index.

The bet can be in either direction, meaning that traders can use CFDs to make profits from falls as well as rises in the price of a security. 

Example of a CFD trade in practice:

Now in this quick introduction to CFDs we’ll show you how a CFD trade works. For more info visit CMC Markets. 

Let’s say a trader wishes to take a buy position on £10,000 of BP plc shares because they believe they will go up in value. 

The CFD provider will quote them a buy price, which will be a function of the mid-market share price on the London Stock Exchange, plus a ‘spread’, which provides a small margin to the provider.

The trader can accept the offer, and the trade will be automatically confirmed.

A CFD is an open-ended contract, so the position could remain open for just a matter of minutes or several days. So long as the position remains in profit or a moderate loss, the choice of when to end the trade is entirely under the trader’s control. 

However, the trade may be closed early by the provider if the losses begin to approach the total amount of cash in the traders’ account. Providers operate under the reasonable expectation that a trader must always hold enough cash on hand to settle any loss-making positions.

Additional fees will apply if the position is not closed within the same day, but we’ll cover that later. 

When the trader closes the position, the provider calculates the profit or loss for the trader, based upon the final closing price, compared to the price at which the trader opened the trade. 

In our example, if the buy price was £3.00 and the position was closed at £3.30, then the profit can be roughly worked out as £3.30/£3.00 = 10% profit * £10,000 underlying position size = £1,000 cash profit. 

The profit or loss is quickly cash-settled to the traders’ online account.

CFDs are derivatives

An important distinction between CFD trading and share trading through a stockbroker is that when you trade CFDs you do not own the underlying asset. Instead, you are party to a Contract for Difference, i.e. an agreement between you and the provider that references the market price of an underlying asset. 

CFDs are therefore an example of a derivative; a financial instrument that derives its value from another asset.

CFDs are regulated and firms are required to comply by rules set out by the FCA. Find out more here.

CFDs include leverage

When a trade is opened, CFD providers do not require the trader to hold the same value of cash in their account as the notional size of the buy or sell position. The value of the full underlying instruments is not deducted from the traders’ account nor placed on ‘hold’. 

For example, let’s say a CFD broker could offer a margin of 20% on individual share trades. This means that a trader needs to only hold £2,000 cash in their account to place a £10,000 ‘buy’ order.

This means that CFD trading is a form of leveraged trading, also known as trading on margin.

The most leveraged asset class is forex. At the time of writing, you can find on the online trading market a 3.3% margin on some major currency pairs, which provides 30:1 leverage. This means a £10,000 forex position can be entered into with £330 of cash upfront. 

The asset class with the lowest leverage available is the market for individual shares; with margin rates starting at 20% (5:1 leverage). Margin rates for commodities start at 5% (20:1 leverage) and the margin for treasuries (government bonds) starts at 3.3% (30:1 leverage). 

Trading with leverage introduces additional risks for both parties. As a trader, your risk of higher losses increases because your underlying position is much higher relative to your capital. The provider takes on credit risk because your potential losses become higher than the cash value in your account.

Spread bets and CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. The vast majority of retail client accounts lose money when spread betting and/or trading CFDs. 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.

We hope you’ve enjoyed this introduction to CFDs.