What is CFD trading?


Contracts for difference (CFDs) are one of the world’s fastest-growing trading instruments. A contracts for difference creates, as its name suggests, a contract between two parties speculating on the movement of an asset price. The term ‘CFD’ which stands for ‘contract for difference’ consists of an agreement (contract) to exchange the difference in value of a particular currency, commodity share or index between the time at which a contract is opened and the time at which it is closed. The contract payout will amount to the difference in the price of the asset between the time the contract is opened and the time it is closed.

If the asset rises in price, the buyer receives cash from the seller, and vice versa. There is no restriction on the entry or exit price of a CFD, no time limit is placed on when this exchange happens and no restriction is placed on buying first or selling first. CFDs are traded on leverage to give traders more trading power, flexibility and opportunities.

A CFD allows a trader to gain access to the movement in the share price by putting down a small amount of cash known as a margin. Trades are conducted on a leveraged basis with margins typically ranging from 1% to 80% of the face value of the financial instrument. For indices or currencies, these margin requirements can be as low as 1 percent of the underlying value of the security.

When you enter a CFD contract you are not buying the underlying share, even though the movement of the CFD is directly linked to the share price. In fact, CFDs mirror the movement and pricing of the underlying share. However, since you do not own the share, you are only required to provide a deposit to your CFD provider which could be as low as 5% for blue chip shares. This means you can trade up to 20 times your initial capital and it thus possible to create significant profit through ‘margin‘ as you only have to use a deposit to hold a position, meaning only a small proportion of the total value of a position is needed to trade allowing the client to magnify market exposure.

For instance, with a stock CFD that requires a 5 per cent margin to open a trade, a 5 per cent increase in the market price of the underlying stock results in a stunning 100 per cent return on the investor’s capital. However, this cuts both ways and there need only be a 5 per cent fall in the market price of the share to result in a 100 per cent loss for the investor.

Ability to Go Long or Short:
CFD trading enables you to go long (buy) if you believe market prices will rise, or go short (sell) if you believe market prices will fall. So if you believe that a company or market will experience a loss of value in the short term, you can use CFDs to sell it today, and your profits will rise in line with any fall in that price. However, if the market moves against you, your losses will also increase. CFDs are therefore a flexible alternative to trading the movements of market prices as they enable you to benefit from any move, regardless of whether the markets are rising or falling.

Hedge your portfolio
If you believe your existing portfolio may lose some of its value, you can use CFDs to offset this loss by short selling. For example, let’s say you hold £5,000 worth of Vodafone shares in your portfolio. You can short sell the equivalent of £5,000 worth of Vodafone shares through a CFD trade. Should Vodafone share prices fall by 5% in the underlying market, the loss in value of your share portfolio would be offset by a gain in your short sell CFD trade. Many investors today use CFDs to hedge their portfolio, especially in volatile markets.

Offset your Losses
CFDs can be extremely tax efficient as, depending on your circumstances, you can use any losses you incur to offset against your Capital Gains Tax (CGT) liabilities. For more information, we recommend that you seek independent investment advice.

24-Hour Dealing
We recognise the importance of being able to access your account and trade whenever you want, wherever you are, particularly when market prices are moving quickly. We therefore give you unrestricted access to your account 24 hours day, 7 days a week. Furthermore, we run a number of our markets 24 hours a day, including major indices such as the UK 100 and Wall Street, meaning you can trade CFDs even if the underlying markets are closed.

Trade on Leverage
CFDs are traded on leverage, meaning you pay only a small fraction of the total trade value to open your position rather than paying for it in full, this is known as margin. For example, you can trade Vodafone shares by depositing a margin of just 4%. Our margins for the UK 100 and Wall Street start at just 0.5%, while margins for our major currency CFDs start from just 0.5%. You can use leverage to magnify your return on investment as your full trade exposure is much more than the initial deposit required for your trade. However, your losses are magnified in exactly the same way if the market moves against you and can lead to losses exceeding your initial outlay. Please ensure you fully understand the risks involved and seek independent advice if necessary. At City Index, we offer a range of risk management tools to help protect your trades against potential losses.

There are two different types of CFD brokers. While these brokers each have their own point of difference for marketing purposes, they can be broadly broken down into two distinct types, offering similar but crucially different services for CFD traders. But what are the differences between these two classifications, and how do you settle on the right type of broker for your trading needs?

Direct market access (DMA) brokers enable 100% transparency in pricing and trading, opening up the global CFD markets to the trader. When a CFD trade is executed at a given price, the DMA broker effectively plays no role whatsoever – the trade is placed in the real-life markets directly, and must be met by a corresponding trade on the other side of the table in order to be fulfilled. Direct market access brokers are in it just for the transaction commission – they are simply the hands-free middle-man, offering an interface between the trader and the markets at large. This means that on the one hand, the price you pay for your CFDs is absolutely and solely a reflection of market rates – there are no other factors playing into pricing.

However, this also means that each transaction requires a live counterparty, which in turn affects the liquidity of the market. The second main type of CFD broker is the Market Maker. Market makers are involved in actually making the markets for the CFDs themselves, which they then hedge in order to counterbalance their risk. Rather than serving as merely a portal between the trader and the markets, market makers are the market as far as the trader is concerned, and it is their pricing that is used as the basis for buying and selling contracts.

This naturally means that pricing isn’t quite as good as on the real markets. That makes sense, given the extra layer of input and risk absorbed by the market-making broker. However, where market makers really shine is in delivering much more real-time liquidity.

Regardless of the demand for the CFDs you’re selling, or the supply of the CFDs you’re buying, market makers execute traders often with considerably less delay than is the case in the real-life markets, because the broker is the market maker – i.e. the broker is the counterparty to the trade, rather than some other investor or fund that must be matched to your trading position.