What is CFD trading? How does a contract for difference work? And what should you look for in the best CFD broker? We explain.
Contracts for Difference (CFDs) are an increasingly popular way of accessing a wide range of markets, including gold, foreign currency and stocks and shares, without trading directly.
What is CFD trading?
A contract for difference is a contract between a buyer and a seller to pay the difference between the opening and closing value of an underlying asset (shares, gold, currency) in cash when the contract is terminated.
You trade CFDs in a similar way to trading ordinary shares or commodities. The prices quoted by CFD online brokers are typically the same as the underlying price of the share or commodity and you can trade in any quantity.
You will usually pay a commission on the trade and the total value of the transaction is simply the number of CFDs bought or sold multiplied by the market price.
However, unlike conventional share or commodity trading where you pay the full amount of the transaction value, with CFDs you only make a small paymet upfront. This is called the ‘margin’ or ‘leveraging’ which means you can achieve a much greater exposure than you can through traditional trading.
For example, if you bought 300 IBM shares at £100 per share using traditional share dealing, you would have to pay £30,000 upfront. If you were then able to sell IBM shares at £105 you would stand to make £1,500 which is a return of 5%.
However, if you had used contracts for difference you could have bought 300 contracts of the share for, say, a 10% margin (£3,000). This reduced cost is referred to as the ‘CFD initial margin’.
If you were then able to sell at £105 you would still make a profit of £1,500, but your return on capital is now 50% (you have made a profit of £1,500 on an investment of just £3,000).
However, it's essential to realise that while CFDs can allow you more flexibility when you bet on the movement of a market, the potential for loss is also great too and there is a significant amount of risk to your capital involved.
For this reason it's imperative to only ever trade CFDs with funds that you could genuinely afford to lose, and to take steps to cap your losses so you don't end up in a financially difficult situation.
What to look for when looking for the best CFD trading platform
There are lots of CFD online trading platforms and so it pays to shop around before you pick a CFD broker.
When you look for a CFD trading platform, compare:
- Whether the company offers ‘virtual trading’ (the opportunity to practice your trading and develop strategies without using your own cash)
- Whether ‘mobile trading’ is offered – the ability to place and settled contract for difference trades using your mobile phone
- The commission you will pay when you trade CFDs – this varies from company to company and also varies between the shares and commodities you will trade
- The markets you have the option to trade on
- The loss limiting tools available (such as guaranteed stop losses), whether these are fixed or determined by you, and if there is any charge for using them
Always carefully research the commissions that you will pay and the tools available before you apply for a CFD account.
The best CFD broker is likely to be one that offers competitive commissions for the markets you want to trade as well as a good online and mobile service.
