What is it?
A Contract for Difference (CFD) is a leveraged investment which means you do not need to commit all your money to a single trade.
Also known as trading on margin, you only need to put down a percentage of the trade to open your position, which is usually between 0.1% and 1%.
This gives you flexibility to spread your investments over several trades in multiple markets, such as:
Shares in companies
Indices, such as the FTSE 100
Commodities, such as gold and silver
It is when you commit to buying or selling a financial investment.
For example, when you buy a CFD in the FTSE 100.
It is when you initially buy or sell a CFD. To close your position, you must do the opposite action.
For example, you buy a CFD in the FTSE 100 (opening your position) then sell the CFD at a later date (closing your position).
How does it work?
When you make a trade you get two prices, the buy price and the sell price:
If you think a value will go up, you could go long and buy a number of CFDs
If you think a value will go down, you could go short and sell a number of CFDs
The price difference between the two is known as the spread. To make a profit, you need to close your position after the price has moved more than the value of the spread.
For example, if the buy price for the FTSE 100 is 6801 and the sell price is 6800, the price would need to grow by more than 1 point* to make you a profit.
How does the spread work?
When choosing a CFD trading platform, the main thing to look out for is the size of the spread.
The smaller the spread, the smaller the market movement needs to be to give you a profit, for example:
Platform A has a sell/buy price on the FTSE 100 worth 6800/6801 (one point spread). The market would need to rise by two points to give you a profit.
Platform B has a sell/buy price on the FTSE 100 worth 6798/6801 (three point spread). The market would need to rise by four points to give you a profit.
What is the margin?
It is the amount you need to put down to open your CFD trade, and varies between different CFD companies.
For example, if the margin for a trade is 1%, and you want to buy 100 FTSE 100 contracts with a sell/buy price of 6800/6801, you will need a deposit of £68.01 (1% of 6801).
The margin acts as a deposit which covers some of your losses if the trade works against you.
Your losses could still exceed your deposit, so make sure you understand the risks involved before you start trading.
How can you make a profit?
When you make a CFD trade you buy a number of contracts. If the market moves in the direction you predict, you could make a profit.
Here is an example of how a CFD trade could make or lose you money:
The sell/buy price for the FTSE 100 is 6800/6801, meaning each contract at the sell price is worth £6,800, or £6,801 for the buy price
If you buy five CFDs, the value of the trade would be worth £34,005 (5 CFDs x £6801)
You only need to put down a 1% margin to open your trade, worth £340.05 (1% of £34,005)
To make a profit, the sell price needs to exceed the buy price you bought your CFD at, for example:
You sell your five CFDs when the sell/buy price is 6806/6807
Multiply the sell price by the amount of CFDs to give you £34,030 (5 x £6806)
Subtract this amount by your original contract value, £34,030 minus £34,005, and you have a profit of £25
If the sell price is below the amount you bought your CFDs at, you would make a loss, for example:
You sell your five CFDs when the sell/buy price is 6796/6797
Multiply the sell price by the amount of CFDs to give you £33,980 (5 x £6796)
Subtract this amount by your original contract value, £33,980 minus £34,005, and you have a loss of £25
What are the fees?
Here are some other charges you may find when trading CFDs:
Overnight trade interest charge: Some CFD companies set an interest charge of around 1.5% for any trades you leave open over night.
Funding/withdrawal fee: Some companies charge you to withdraw or add money to your account, such as a set fee of £5 for every £200.
Inactivity fee: If you have not traded for a set term, such as two years, you could face a monthly charge of around £12 until you close your account or start trading again.
Check each company's charges before you start trading to find the cheapest platform.
Do you have to pay tax?
You do not have to pay income tax or stamp duty when you invest in CFD trading.
If your profits exceed £11,300 in a single tax year (6th April until the following 5th April) you have to pay Capital Gains Tax.
However, you can offset any Capital Gains Tax with any losses you make when CFD trading.
What to do next
Here are some top tips to follow before trading in CFDs:
Open and use a demo account to familiarise yourself with your chosen platform
Only make trades on markets you understand
Do not make an emotional trade, like if you want to make up from any big losses
Do not make trades until you have taken the time to research the market, and make sure you only trade the amount of money you can afford to lose.
It lets you make practice trades without investing any of your money, so you can get used to the features available on the platform you choose.
You can open a demo account with your chosen platform by going to their website and choosing where they offer a demo account registration.
Is CFD trading a type of gambling?
No, but there is a high chance you could lose the money you invest, even if you do a lot of research.