What is CFD Trading & How Does it Work? | A complete Guide
CFD trading is a way of investing in financial markets that uses derivative instruments to take advantage of both the upside moments of an asset and the downside moments.
Whatever the motivation that drove you here, and whatever your level of financial knowledge, we have good news for you. In fact, we want to share a series of information that will be very useful for you to improve your investment strategy in contracts for difference!
But first, we want to give you a little starting tip. In order to make the most of the information you will find below, you must rely on the best online brokers in the world.
For those starting from scratch, the best choice is eToro, which allows you to trade CFDs even simply by copying the operations of other traders on the platform. In this way, even without experience, you will be able to obtain their same results (in proportion to the invested capital).
CFD trading meaning
Let's start with the basics: what is CFD trading?
We define the CFD - contract for difference as a contract between two parties, through which they agree to pay the difference between the opening price and the closing price of a particular underlying financial instrument.
Therefore, there is no actual purchase or sale of financial instruments, but only the existence of an agreement (in this case, between the trader and the broker) to regulate the difference in value between the opening and closing price. of the location.
With these specificities, investing in CFDs is a way to speculate on the movement of prices, without owning the underlying asset. You can therefore try to earn with CFD trading without however getting hold of gold, currencies, cryptocurrencies, commodities, stocks and much more!
The mechanism of action is quite simple. The performance of the CFD reflects the price and the price trend of the underlying asset. The profit and loss are established constantly, as the value of the underlying asset moves with respect to the position of the opening price.
So, when you close a CFD position with the broker, you will get:
a loss if the price of the underlying asset has moved in the opposite direction to the one you predicted;
a profit if the price of the underlying asset has instead moved in the same direction you predicted.
For now, keep these concepts in mind:
when you trade a CFD with a broker, you do not own the asset being traded, but you are only speculating on the movement of the price, up or down: it is the best way to trade online;
the market need not necessarily be growing. In fact, you can make a profit even in a falling market, as long as you have correctly predicted the direction.
Easy, right?
How does CFD trading work?
To be able to understand even more clearly how CFD trading works, let's take a practical example.
Let's imagine that you want to invest in a stock that is listed on the Milan stock exchange for 25 euros, and that you want to invest in 100 shares of the company.
It follows that, if you were to buy a share in the traditional way, the budget to be allocated for this operation would be 2,500 euros (25 euros x 100 shares). To all this you will also need to add commission or trading costs, which could further erode your margin!
With CFDs you can act in different ways:
you can for example trade CFD shares without leverage. In this case you will be able to carry out the same operation as above, with even greater simplicity and other charges;
or, you can trade leveraged stock CFDs. For example, if you want to invest in stocks with 2x leverage, it means that in order to open a position of € 2,500 you would only have to deposit € 1,250. The other part will be "loaned" to you by the broker, which will therefore allow you to immobilize less capital, while aiming for greater profits (but be careful, the losses will also be greater!).
But why is trading CFDs free (i.e. commission-free)? The reason is in the fact that brokers get their income in another way - the spread.
When you open a position with a CFD, you will notice that the position will be opened immediately with a small "loss" equal to the size of the spread. This means that if your broker's spread is 5 cents, then you will need the stock to appreciate by at least 5 cents to break even.
How to trade with CFD contracts
Now that you have more information on what CFD trading is, what the advantages and what the disadvantages, let's try to understand, step by step, how you can invest in CFDs with the best brokers on the market.
We refer to platforms such as eToro (official website), Trade.com (official website) and Plus500 (official website).
Choose a market
There are tanmarkets you to choose from. For example, you can invest in currencies, commodities, stocks and indices. Try to choose a market you know well, especially at the beginning, because this will help you react to market developments with the right awareness.
Buy or sell?
If you buy you go "long", if you sell you go "short". All major trading platforms allow you to invest in both directions with equal ease.
Remember that the price of your CFD is based on the price of the underlying instrument. And so if you have reason to believe the market will grow, you should buy. If you think it will go down, you should sell.
How much to invest
Now you need to select the size of the CFDs you want to trade. Brokers generally have rather low investment limits, thus allowing anyone to be able to start investing even with very low capital.
Even the minimum deposit to start trading CFDs is within everyone's reach: € 100 is often enough to start.
Stop loss and take profit
Imposing stop loss and take profit will help you better manage profits and limit losses. Most CFD strategies for beginners and for experienced traders ALWAYS use the use of stop loss and / or take profit.
Therefore define them in line with your risk management strategy. Once set, the broker will automatically close the short or high position once the price has touched the set limits.
Where to trade CFDs
Here is the table with the best CFD trading platforms:
eToro
eToro is the leading platform for online trading, a success certified by the over 20 million users who invest on its platform every day.
Here you will find a huge catalog of CFDs available for trading: the broker covers almost all existing markets, from stocks to indices, from forex to cryptocurrencies, not to mention commodities and also many ETFs.
All at really advantageous conditions: the spreads, in fact, are among the cheapest on the market.
What makes the difference, on eToro, is the presence of social trading: all users have the opportunity to interact with each other, comparing and exchanging opinions and advice on the strategies to follow in their investments.
The social trading revolution, however, is much more: eToro allows you to copy the operations of other users, using a practical internal search engine that also allows you to set filters based for example on returns or risk appetite.
In this way, even if you are not familiar with CFD trading, you can still get the same return as a more experienced trader simply by copying his trades. The return, of course, will be proportional to the capital you have decided to invest.
This tool is called Copy Trading and is also available in free and risk-free demo mode.
XTB
XTB is a CFD broker with a very interesting catalog, on which it is possible to invest with competitive spreads.
Its strength is the attention paid to the growth of users, who can register for free in xStation Academy.
We are talking about a complete training course, structured in modules of increasing complexity. You can start with lessons designed for beginners, gradually developing your skills up to advanced modules.
The simple language and the numerous practical examples make learning within everyone's reach, even those who have never opened a book on economics.
The educational value of this resource is really high but XTB has decided to offer it for free to all its members.
Here, too, a free demo mode is available, which will give you unlimited access to all the tools on the platform.
Capex
Capex has attracted the attention of the general public for its ability to offer, within a single service, both CFD trading and the technical tools to operate in depth.
In fact, traders usually turn to external services to obtain reliable information and forecasts to develop their strategies.
Capex, on the other hand, has entered into a partnership with Trading Central, a prestigious financial analysis company, which offers its services free of charge to all members of the broker (externally to the platform they are instead sold by subscription).
By operating on the Capex platform, therefore, you can receive notifications in real time with:
forecasts on the daily trend
advice on strategies to follow
technical indications on points of interest on the price chart
Since these are indications received from an extremely reliable source, you will know that you can adapt your strategies in the best way, with the professional support you need.
You can test Trading Central's services by opening a free and risk-free demo account.
Leverage CFD trading
The leverage of CFDs is one of the reasons why we often resort to trading with contracts for difference, rather than direct trading with the underlying assets.
The leverage provided by brokers such as eToro (official site) essentially depends on the type of financial instrument (it is lower for cryptocurrencies, for example, while it is higher for shares).
Thanks to leverage, you can take large positions with less capital. However, as we have already had occasion to recall a few lines ago, although in this way you can earn large figures faster, it is also true that the losses will be much larger.
Why trade CFDs?
Is trading CFDs worthwhile?
By now, you should have already understood what the main advantages of CFD trading are. However, let us try to clarify them, in a synthetic list:
best cfd brokers
Accessibility - the best CFD brokers such as eToro (official website), Trade.com (official website) and Plus500 (official website) will allow you to trade in all major financial markets in the world, even 24 hours a day (thanks, for example , to Forex). In short, you will have access to an infinite number of opportunities, within which to choose the ones that best relate to your financial strategy.
Cost-effectiveness - CFD trading has minimal costs. The best traders that we report to you on this page do not charge any commission to enter and exit positions because, as we have already reminded you, they earn their profits with the spread. The size of the spread will depend on the volatility of the underlying asset and, as a rule, it is a fixed or variable value depending on the investment platform chosen.
Short selling - even if in some moments it will not be possible to short sell (as happened on some occasions in the coronavirus epidemic), with CFDs you can earn both with a growing market and with a declining market. In short, you will not necessarily have to wait until the market is in a growing phase to be able to earn: it is sufficient that you correctly predict the evolution of the prices of the underlying asset you want to trade.
CFD trading risks
Of course, like any financial sector, CFDs also have risks that you shouldn't underestimate:
Regulation - the CFD industry is not fully regulated. This means that it is essential to know how to choose the right broker to avoid all sorts of problems.
Trading on margin - although, as we have already mentioned, margin can increase your profit potential, it also increases risk! It is very easy to lose sight of the total exposure that one has when using a rather high financial leverage. Precisely for this reason our suggestion is to start trading with CFDs without financial leverage or with very low financial leverage.
Train using a demo account, like the one you find on the official eToro website. Once you have understood how leverage works, you can proceed with the completion of CFD trading operations in financial leverage with real money.
Best CFD trading strategies
Choosing a good market to invest in is not easy, but without an effective strategy, making a profit will be almost impossible. You will therefore have to devote a large part of your initial efforts to finding a strategy that fits your trading style.
What are the best CFD trading strategies?
One is certainly the breakout, which simply requires the identification of a key price level for a given stock. When the price reaches the key level, you will need to buy or sell, depending on the trend.
The main thing to remember with breakout trading is to avoid any trades when the market does not provide clear signals.
The second strategy is the contrarian one. In this case, your plan is essentially based on the knowledge that trends don't last forever.
If a stock's price is falling, then a point is identified where it is believed to be near the end of the trend. Then, you enter a buying position in anticipation of the trend turning in the other direction. Of course, you can follow exactly the same procedure if the price is rising!
How to calculate Profits and Losses in CFD trading
Let's continue to investigate how CFD trading works by taking the example above. So let's imagine that the price of the underlying security continues to increase and reaches a price of 26 euros, from the initial 25 euros.
In the event that you have invested in non-leveraged CFD trading, then your capital is now worth € 2,600. A nice profit, net of the spread, equal to 100 euros.
If, on the other hand, you had invested with 2x leverage, you would still have obtained a profit of 100 euros, but immobilizing half of the capital. So, in terms of percentage, the CFD would have returned you much greater profits!
Warning: if the market had moved in the opposite direction, in fact, even the losses compared to your initial investment would have been greater.
Remember, therefore, that both risk and profit are greatly increased due to leverage, and that you should handle this tool with particular care.
Conclusions
We hope, on the sidelines of this in-depth analysis, that we have provided you with sufficient elements to be able to correctly understand what it means to trade CFDs and what you need to do to start investing in contracts for difference.
Always remember that it is essential to choose a regulated broker with whom to trade online and that before making investments with real money, it is always good to train a little with a demo account!
To start trading CFDs safely, starting from scratch, eToro Copy Trading is the most suitable tool for you.
Click here to find out more about eToro Copy Trading
What is CFD trading?
CFD trading is based on the purchase and short sale of derivative financial instruments that replicate the performance of an underlying asset.
How does CFD trading work?
If an asset is expected to go up, you need to open a long (bullish) CFD position. Conversely, if a decline is expected, a short (bearish) CFD position must be opened.
Is trading CFDs worthwhile?
Investing with CFDs allows you to save on commissions: the only cost is that related to the spread. Furthermore, it is possible to take advantage of both the rising moments and the falling market moments.