CFDs. What are they, how do they work and why might you consider using them?

Good trading ideas come in many different guises, particularly in volatile markets. The Covid-19 outbreak has brought a marked shift in fortunes for many companies, currencies and economies. Contracts for difference (CFDs) are a useful way to target precise exposure to rising or falling markets.

CFDs are not an asset or security in themselves, but instead are derivatives that track the price movements of underlying assets or securities. They allow investors to take positions on the change in price without ever having to own the underlying asset. This means they can benefit from a rise (or fall) in its value at only a fraction of the cost. This ‘leverages’ the trade, magnifying gains or losses.

CFDs can be used on a variety of instruments – indices, currencies, individual shares, commodities and ETFs- across the globe. Your initial deposit will depend on the size of your position and the ‘margin factor’ for the individual financial asset. Higher risk assets may require a higher deposit.

CFD trading in action

CFDs can be useful to exploit mispricing in the market. As an example, you may think a great new product from company X is being overlooked by the market and the share price is due for a revival. You choose to buy 10 CFDs on the company at a price of £300. Let’s say the margin is 20%, so your initial outlay is £600 (£3000 x 20%).

If it turns out you’re right and the company share price moves to £325, each CFD is now worth an extra £25. The profit you have made from this trade is £250 (10 x £25). This is significantly more from a lower initial outlay than if you’d simply bought the shares.

However, your losses would also have been magnified had the trade gone against you. If the share price drops to £275, your loss is also £25 x 10 or £250, almost half your initial investment.

When to use CFDs

In many ways, CFDs are more flexible than other forms of trading because you’re only betting on the difference in price, rather than buying and selling the assets outright. This makes it easier to take a position on a falling price. Because CFDs are leveraged instruments, CFD trading is also a way to take maximum exposure to an individual asset for minimum cost.

CFDs may also be used for hedging. For example, if you believe that the market is likely to go lower in the short term, but don’t want the expense and hassle of unwinding your whole portfolio, you can potentially use CFDs on major indices such as the FTSE 100 or S&P 500 to profit from falling markets and offset the impact on your wider portfolio.

Managing risk

The risks are higher, particularly when using CFDs to bet on the fall in the price of an asset. The price of an asset can theoretically rise indefinitely, which means losses can mount up. Traders may be caught out by a company’s sudden revival, a takeover deal or a new management team being put in place. Areas such as currencies and commodities tend to be volatile and prices will be influenced, sometimes swiftly and unexpectedly, by day to day market news.

As such, it is worth putting risk parameters around any trade. For example, it is possible to sell out of a trade automatically if losses exceed a certain amount (‘stop loss’) or if profits hit a certain level (‘take profit’). These parameters can be customised to give an appropriate level of protection. It is also important to have quantified any potential loss ahead of instigating the trade. The Fineco platform allows users to practice with a model portfolio before using real money.

How are CFDs different to futures?

Futures are another type of derivative and can be used in similar ways to CFDs. Futures contracts govern the purchase and sale of an asset at a specific price on a specific future date (in contrast to a CFD, which has no set future price and no set future date). They tend to be cheap, liquid and have a narrow bid-offer spread but you have to pay a commission. They can also be traded on a wide range of assets, including indices and commodities.

Futures are traded on an exchange, which means the overall minimum trade size tends to be larger. CFDs are traded by individual brokers, tend to be more flexible in terms of trade size – its easier to trade in smaller amounts - and can provide greater choice of assets to trade on.

Interested in CFD trading? You can trade Share CFDs with Fineco for zero commission and zero additional spread. Your only impact on trading is the market spread. CFDs on a wide range of other instruments, including currencies, indices, commodities and bonds can also be traded at competitive prices.