The Ultimate Guide to Contracts-for-Difference (CFDs): What They Are, How They Work, and How to Trade

Contracts-for-Difference (CFDs) offer traders and investors a versatile financial instrument to speculate on the rise or fall of various asset prices.  

This comprehensive guide will navigate you through the intricacies of CFDs, from basic concepts to advanced trading strategies. Whether you’re new to the world of financial derivatives or looking to refine your trading skills, this guide provides the valuable insights you need to engage in CFD trading effectively.  

Key Points 

• Contracts for Difference (CFDs) are financial derivatives that allow traders to speculate on the price movements of various assets without owning the underlying assets. 
• CFDs work by settling the difference in price of an asset between the opening and closing of a trade, with options for both long and short positions using leverage to amplify results. 
• Various trading strategies, such as day trading, swing trading, and position trading, cater to different trader goals and risk tolerances, utilising both technical and fundamental analysis to guide trading decisions. 

Understanding CFDs ^[1] 

What are CFDs?  

CFDs are a type of financial derivative that allows exposure to the price action of different asset classes without direct ownership of the said asset class.  

In other words, CFDs allow traders to trade the asset classes they want without having to buy or sell the underlying security. This may sound strange to the uninitiated, but as you’ll soon learn, trading CFDs could provide specific benefits and advantages not found in conventional securities.  

Furthermore, CFDs are highly flexible and can be applied to a wide range of assets, including shares, indices, commodities, bonds, and forex. This is another reason for the popularity of CFDs in investing.  

Of course, CFDs are not without their drawbacks. For one, they are an advanced trading method that takes time and experience to master. For another, CFDs can be traded on leverage, which requires discipline and proper risk management. Additionally, depending on the market or asset chosen, CFD trades can experience high volatility over short periods, which beginners or inexperienced traders may find challenging to manage.  

CFD trading can be advantageous, but success is not guaranteed for those without the proper mindset, skills, and knowledge. It is advisable to adopt a cautious approach with a strong emphasis on risk control at all times.  

How do CFDs Work? 

CFDs are an agreement (or contract) between two parties (a trader and a broker) to exchange the difference in price of a predetermined asset between the start of the agreement and the point at which the deal is closed.  

Note that CFD traders never actually own the underlying asset, but instead receive returns or incur losses based on the price change of the asset. Hence, CFD trading is preferred for those who wish to speculate on price action in their chosen markets.  

A CFD trader may choose between taking a long or short position, although only one may be selected from per contract. As asset prices fluctuate in real time, the value of the CFD changes in tandem. This creates the possibility of a gain or a loss along any point of the contract, depending on the position taken and how the asset price moves.  

Using leverage will amplify the impact of the price movement. Thus, experienced traders who use leverage skilfully can amplify returns from a winning trade. It’s important to recognise that leverage will also enlarge losses should the trade turn against your position.  

Traders can hold their CFD positions open for as long or as short as they wish, making CFDs suited to a wide variety of trading strategies and timelines.  

However, a sufficient account balance is required to keep positions open during periods of volatility, when prices swing wildly. Should the position deviate too much, a margin call may take place, requiring more funds to be deposited into your trading account to maintain your position.  

Failing to meet a margin call will cause your position to be unwound immediately, resulting in losses to your account. Note that because leverage increases the magnitude of your trade, a leveraged trade may increase the possibility of a margin call. 

Trading Example of a CFD  

To illustrate how a CFD trade might work, here’s a hypothetical example. For simplicity, we are ignoring fees and commissions and will not be using leverage. 

• Stock price: $20 
• No. of shares: 100 

Believing the stock price will go up in the near future, Bill opens a long position of 100 shares in a CFD.  

The next day, the share price goes up to $21. At this point, Bill can close his CFD for a profit of $1 per share (less fees and commissions).  

However, if the next day, the share price falls to $19, Bill is now sitting on a loss. He can cut his losses by closing his position or keep his CFD open in the hopes that the share price reverses and rises above his cost basis, allowing him to avoid any losses.  

On the other hand, if Bill had believed the share price would fall, he would have opened a short position. If the share price indeed falls, his short position would be profitable.  

How to Trade CFDs? 

CFD Trading Strategies ^[2] 

Due to their flexibility, CFDs can be traded with a variety of different strategies. Traders may choose different CFD trading strategies based on their goals, risk tolerance, and time horizon. Here are some commonly used CFD strategies: 

Day Trading 

Day trading seeks to generate returns from a series of CFD trades opened and closed within a single day. A defining characteristic of day trading is that positions are rarely (if ever) kept open overnight to avoid overnight volatility risk.  

CFD day traders should have quick decision-making skills and a disciplined approach to reduce risk and work towards steady daily revenue.  

Swing Trading 

Swing trading attempts to capitalise on the price change of an asset as it swings from one trend to another. Such changes can occur over time frames ranging from a few days to several weeks.  

To be successful, swing traders need to spot incoming price swings and act on them promptly.  

Position Trading 

Position traders take long-term trades, maintaining them for weeks, months, or even years. The aim is to profit when the trade arrives at a winning position. 

In position trading, short-term market noise is ignored in favour of longer price trends. Success hinges on identifying a long-term price trend and having the conviction and patience to hold the trade until the trend runs its course.  

Position trading may sound similar to a long-term buy-and-hold strategy, but the difference is that a position trader may take either long or short positions.  

Discover the key differences between position trading and swing trading with our comprehensive guide. 

Trend Following 

In trend following, the trader follows the principle “the trend is your friend, until it is not”. Essentially, once a trend starts, whether upwards (bull trend) or downwards (bear trend), the market tends to follow the trend.  

Thus, the job of the trader is to trade along with the trend (taking long positions during bull trends, and short positions during bear trends), and continue doing so until a trend reversal occurs.  

It sounds simple, but in practice, correctly identifying price trends is notoriously difficult and requires knowledge and experience. Technical indicators are often used to help identify, confirm, or deny price trends.  

Technical analysis in CFD trading  

Technical analysis is an essential skill in CFD trading because it focuses on asset price movements. It involves learning to read a price chart to identify patterns that may indicate similar future price action. ^[3]  

The need to decipher the information provided in price charts has given rise to numerous technical indicators, each with varying functions. Traders skilled in their use can improve their ability to read the market and derive better trading outcomes. Some specific benefits include:  

• Price prediction: Technical analysis can help traders forecast future price trends based on previous patterns. This can help establish more accurate entry and exit points.  
• Risk management: Technical analysis is instrumental in risk management, as it identifies appropriate stop-loss and take-profit levels based on support and resistance levels.  
• Timing trades: Traders can use technical analysis to determine whether their market is overbought or oversold, reducing the risk of opening a trade at an inappropriate time.  
• Confirmation: Technical analysis is particularly useful for specific trading strategies, such as trend-following or position trading, as it can quickly confirm an ongoing trend or signal a reversal.  

Popular Technical Indicators and Chart Patterns ^[4]  

Moving averages 

A moving average levels price data over a specified time period, creating a constantly updated average price. This allows traders to ignore short-term market noise for a more accurate read of the situation.  

Because they are based on past prices, moving averages are thus lagging indicators. Still, they can help identify trends: a falling moving average indicates a downtrend, while a rising moving average signals an uptrend.  

Relative Strength Index (RSI) 

The RSI is an oscillator that measures the momentum of a security (speed and size of price changes) and is widely used to gauge when a security is overbought or oversold. This can help traders decide whether to execute a buy or a sell.  

Moving Average Convergence Divergence (MACD) 

Another oft-referenced technical indicator is the MACD, which measures the relationship between two moving averages of an asset’s price. This indicator shows how the MCAD line moves relative to the signal line, indicating bullish (MCAD line above zero) or bearish (MCAD line below zero) market momentum.  

Additionally, the distance (or divergence) between both lines indicates the strength of the trend – the larger the divergence, the stronger the trend.  

Lines of Support and Resistance  

Lines of support and resistance are lines plotted on a price chart to describe a larger price trend. They are also used to estimate where future prices might land, based on prevailing trends. Support lines may be thought of as the price floor, and resistance lines, the price ceiling. 

The more times the price bounces off the support line, the greater the likelihood of a price breakdown and a bearish trend. Meanwhile, as the price approaches the support line, it could signal a bullish trend.  

Chart patterns 

Candlestick chart patterns are a widely used set of technical indicators; the appearance of specific patterns indicates bearish or bullish trends. They are often combined with other technical indicators to confirm or refute the stated trend, providing traders with a more comprehensive view of the market.  

Fundamental analysis in CFD trading ^[6]  

Fundamental analysis examines the factors that affect the price of a security, stock, or asset. Having a firm grasp of fundamental factors helps traders understand price action and formulate trading ideas.  

In general, fundamental analysis encompasses studying major macroeconomic factors, such as economic reports, geopolitical events, interest rate announcements, and inflation levels. In some cases (such as stocks), fundamental analysis also includes examining a company’s internal factors, including earnings performance, staff changes, and executive-level movements. 

When performed with skill, fundamental analysis can help traders identify potential trading opportunities while reducing risk. 

Analysing economic indicators 

Traders screen key economic indicators, such as GDP growth, inflation rates, and employment figures to gauge the health of an economy. Positive economic indicators, such as strong consumer spending and low unemployment, may drive bullish price action, while negative news may fuel bearish price trends.  

Analysing news and events 

Depending on their nature, news reports, geopolitical developments, and company bulletins can substantially influence asset prices. By tracking key news and events, traders can be better prepared to navigate market changes.  

Explore the dynamics of news trading in our detailed article, ‘News Trading: A Deep Dive into ‘Buy the Rumour, Sell the News’’, learn everything you need to know today. 

Analysing corporate earnings 

When trading CFDs based on stocks and shares, paying attention to corporate earnings is crucial. Earnings releases and the executive comments that often accompany them can offer valuable insights into the performance trends of underlying companies, providing hints regarding their long-term health. 

Such knowledge will help traders make informed decisions on entry and exit points and which strategies to use.  

Getting Started with CFD Trading 

If you’re interested in trying out CFD trading, pay attention to three critical areas: picking the right CFD broker, understanding CFD trading psychology, and how to use leverage responsibly.  

Choosing the Right CFD Broker 

Your choice of CFD broker can significantly impact your trading success. Here are 10 things to consider when choosing the right CFD broker for you.  

Credibility and security 

When engaging in CFD trading, it’s crucial to select a broker that demonstrates high standards of credibility and security. Look for brokers that provide transparent information about their security measures to protect client accounts from unauthorised access.  

Reputable brokers implement robust security protocols and manage client funds separately from corporate funds to prevent misuse. 

Asset selection 

Brokers offer CFDs across multiple assets, including equities, commodities, forex pairs, indices, and cryptocurrencies. You should select a trading platform that supports the assets you are interested in. Choosing a variety of different assets can help you diversify your portfolio and access a broader range of market opportunities.  

Trading fees and charges  

In exchange for providing CFD trading services, brokers impose a spread on every trade, which the trader bears. There are additional fees to consider. To ensure you’re paying a fair rate in trading fees, look for brokers that offer low fees, narrow spreads, and a transparent fee structure without charges buried in fine print.  

Leverage 

CFD trading is commonly offered with leverage, which can amplify trading outcomes, whether they are profits or losses. The use of leverage is not mandatory and should be attempted only by highly experienced, well-funded traders.  

If you come across a broker that downplays the risk of leverage or seems to encourage leveraged trades, it might be a good idea to steer clear and look for one that does not press the issue.  

Trading tools and features 

Given the complex nature of trading, you shouldn’t be surprised that you’ll need a variety of tools and resources to help you succeed. A top-quality broker would provide access to trading software with features such as technical indicators and charting tools, as well as risk-management tools like stop-loss and take-profit orders. 

Also helpful would be educational and planning resources ranging from e-courses to learning blogs and economic calendars. You’ll know a broker is supportive of your trading journey when such resources are readily available at no extra cost.  

Execution speed and reliability 

In CFD trading, order execution speed and reliability are essential, especially during periods of market volatility. Platforms with slow connections or delayed execution could cause you to miss trading opportunities or dim your trading outcomes through no fault of yours.  

Make sure the platform you choose has a track record of speed and reliability, as evidenced by user and community feedback. 

Customer support 

While this is rare, you may encounter issues when trading. When this happens, you’ll want a quick solution and reliable ways to get it. Check which customer support channels a broker provides – having multiple channels, such as live chat, email, and phone support during trading hours, is preferable.  

Mobile trading 

With smartphones and tablets, traders can trade anytime, anywhere, enabling faster-than-ever responses to developing events. If the idea appeals to you, be sure to choose a broker with mobile trading options that are fast, secure, and reliable. This will allow you to trade on the go whenever you need to.  

Risk management tools 

Effective trading goes hand in hand with proper risk management, and your CFD broker must provide the tools you need. Having a variety of limits and orders available will enable you to implement more advanced risk-management strategies as you develop your trading skills. Similarly, backtesting your strategy can help you avoid losses.  

Account types and minimum deposit 

Brokers typically offer different trading accounts for varying experience levels, with advanced accounts requiring higher minimum deposits. Instead of selecting the highest available account, start with one that fits your trading budget and risk tolerance. You can always apply to upgrade your trading account once you’ve picked up the necessary skills and experience.  

Understanding CFD Trading Psychology ^[7] 

One of the main hurdles to success in trading CFDs is psychology. It is natural to give in to fear or greed, which can lead us to make poor decisions and suffer financial consequences.  

The fast-paced nature of CFD trading further exacerbates the adverse effects of losing control, making it even more important to understand how to manage psychological factors.  

Use the following tips to help you potentially master the psychology of CFD trading.  

Develop a Trading Plan and Keep a Trading Journal  

Failing to plan is planning to fail, and nowhere is this more relevant than in CFD trading. Before all else, develop a trading plan that spells out what trading strategies you will use, which markets you will trade, what is your weekly (or monthly) trading budget, and what is your target profit or loss.  

This will help you focus your efforts on expanding your knowledge in relevant areas (markets and strategies) and on developing your financial framework to ensure you trade responsibly.  

Drawing up your trading plan is only the beginning. Like any good plan, you will need to refine it as you go, incorporating your experiences and outcomes. Keep a trading journal and update it regularly with your trading results. You’ll want to note down what worked and what did not, what mistakes were made, and how you could have brought about a better outcome.  

Over time, your trading journal will become an invaluable asset that helps you discover and develop your own trading style and strategies.  

Adopt Risk Management and Avoid Revenge Trading 

Without proper risk management, even one or two bad trades can wipe out your balance or put your account in the red.  

At its core, risk management is about avoiding being driven by greed or fear. This can be accomplished by strictly controlling how much money to risk on each trade – keeping capital-at-risk below 1% per trade is a good rule of thumb [8]. Also helpful is knowing how to use orders and stops to limit losses and take profits at the right time. 

Failing to maintain control over risk leads to fear or greed taking over, causing us to make mistakes that amplify eventual losses or to stay in a bad trade longer than we know we should.  

By the same token, avoid revenge trading at all costs. Encountering an unexpected loss can feel unfair, and in response, we may feel justified in taking on a riskier trade to try to recoup the loss. This can lead to additional errors and ultimately increase our losses.  

Embrace Patience and Accept Responsibility  

While CFD trading can be potentially lucrative, traders should not treat it as a get-rich-quick scheme. Instead of aiming for significant wins, you may find better results by seeking a steady series of smaller wins.  

Hence, it is helpful to be patient when trading CFDs, as recognizing that it is a numbers game will help you stay motivated to hone your skills and knowledge continually. Adopting a patient approach is also essential for maintaining risk control and avoiding greed and fear.  

It is also helpful to understand and accept that some of your trades will go against you, causing losses. Instead of feeling punished or thinking it’s bad luck, take responsibility for your loss and learn as much as you can from the experience. This way, you have a better chance of avoiding the same outcome in the future.  

Seek Support and Feedback, and Practise Continuous Learning 

It may accelerate your learning to seek support and feedback from other traders, as you can uncover lessons and knowledge as you learn from each other’s experiences. Getting mentorship from more experienced traders can prove immensely helpful, especially if you’re starting.  

But no matter your experience level, recognise that in trading, learning never stops. Make it a point to hone your skills and expand your knowledge continually, and you should see your trading outcomes improve over time.  

Using Leverage in CFD Trading ^[5]  

No discussion of CFD trading is complete without addressing leverage, which we will cover in this section.  

Leverage is using borrowed funds to take on a larger trading position, beyond what one’s own funds would allow. To trade with leverage, traders require a margin account, which a broker may grant based on qualifying criteria.  

In addition to CFD trading, leverage is commonly used in forex trading. But no matter where it is deployed, leverage amplifies the outcome of your trade, heightening profits and deepening losses.  

This is why leverage is often described as a double-edged sword: it can be both helpful and harmful. But just like with any tool, whether leverage helps or harms you depends on how you use it.  

How Leverage Works in CFD Trading 

To see why, let’s go through a simple example of how leverage works in a CFD trade. Note that we are ignoring the effect of fees and spreads for simplicity.  

Let’s say you wish to trade a CFD on a stock with a share price of $200. With a capital of $10,000, you can only purchase 50 shares. 

However, your broker offers you a margin account with 10:1 leverage. That means you only need $1,000 (10% of $10,000) to trade 50 shares, or you can trade the full $10,000 for 500 shares.  

Using leverage, you decide to put down $2,000 to trade 100 shares, opening a long position on the stock.  

If the share price rises 

One week later, the share price rises to $210 per share, resulting in a $10 per-share profit. You decide to close out your position for a total profit of $10 x 100 = $1,000.  

With an initial capital of $2,000, you achieve a total return of 50% on your trade. 

If the share price falls 

What happens if the trade goes against you and the share price falls to S$185? In this case, you would have lost $ 15,000. 

This is equal to 75% of the initial $2,000 capital you put down.  

Leverage vs Non-leveraged Trade 

The effect of leverage is clearer when comparing these results with a non-leverage trade.  

Recall that with 10:1 leverage, trading 100 shares requires $2,000 in capital. However, without leverage, trading the same 100 shares would require total capital of $20,000.  

Now assuming the same outcomes, here’s how much leverage amplifies profits and losses.  

With 10:1 leverage	Without leverage
Profit: $1,000 ($10/share) Capital: $2,000 Total return: 50%	Profit: $1,000 ($10/share) Capital: $20,000 Total return: 5%
Loss: $1,500 ($15/share) Capital: $2,000 Total loss: 75%	Loss: $1,500 ($15/share) Capital: $20,000 Total loss: 7.5%

Note that in our example, we’ve used a relatively low leverage of 10:1. If higher leverage is used – 20:1, or even 50:1 – the amplification of profits and losses will be magnified to a corresponding degree.  

Pros and Cons of Leverage in CFD Trading

Pros	Cons
Amplifies losses (as a percentage of capital) on a losing trade	May face a margin call
Frees up capital	May face margin call
Allows trading with smaller capital	Not suitable for inexperienced investors

To sum up, leverage in CFD trading offers advantages and drawbacks.  

On the positive side, leverage can amplify returns on a winning trade, allowing you to reap a larger profit with less capital. The implication is that you can achieve greater capital efficiency by allocating less capital to achieve the same level of profits.  

You can allocate the remainder of your trading capital to other trades simultaneously, or set aside some cash for sudden market opportunities.  

Similarly, leverage also means you can start trading with lower capital, but it also means that if your trade goes against you, your loss, as a percentage of your capital, will be larger.  

More importantly, traders should be aware that using leverage may trigger a margin call, requiring additional funds to be added to the account. This is most likely to occur during market shifts or periods of heightened volatility, when your trade incurs losses that exceed your margin.  

Margin calls are often urgent; failing to meet a margin call (i.e., make the required top-ups) will result in your position being closed and losses being allocated to your account. This can severely disrupt your financial well-being.  

Hence, it’s crucial to understand that leverage should not be used as a substitute for having sufficient trading capital. Instead, it should be used only to achieve capital efficiency, and it’s essential to maintain the means to meet margin calls if they arise.  

Are CFDs Right for You? 

CFD Trading: What Beginners Need to Know 

Pros of CFDs	Cons of CFDs
Diverse asset classes available	High degree of complexity, requires good knowledge of the market
Can place both long and short trades	A high degree of complexity requires good understanding of the market
No ownership requirement	Some brokers charge high fees

If you’re planning to try CFD trading, start by considering the pros and cons. This will give you a better idea of what you’ll be getting yourself into.  

As summarised above, there are three main benefits of CFDs.  

Firstly, CFDs allow you to trade a wide range of assets and markets. You can trade CFDs for stocks and shares, ETFs, indices, commodities, and even cryptocurrency. This is because CFDs only deal with the price action of the underlying asset, which means as long as there are reliable price feeds (and a willing CFD broker), you’ll be able to trade the markets you want. 

In addition to providing access to popular assets, CFDs are highly flexible. You can speculate on prices going up or down, meaning you can potentially reap returns in both bull and bear markets.  

The third benefit of CFDs is that they require no ownership. To see why this is helpful, let’s consider gold trading.  

If you’re interested in buying and selling gold bullion, you’ll need a way to receive and store your gold holdings securely. This means paying for gold broker storage fees and other middleman services. However, with gold CFDs, you can trade the price action of gold without all these extra considerations.  

On the flip side, CFDs can be demanding in several ways.  

CFD trades can be fast-paced, which can be overwhelming for inexperienced investors who must make quick decisions. Also, if leverage is used, the potential of facing a margin call adds another layer of risk.  

While CFDs are relatively straightforward, success requires deep knowledge and experience of your chosen market to consistently make the right call on which way asset prices will go. 

Lastly, CFDs may be subject to varying levels of regulation depending on the jurisdiction. In some regions, the regulatory framework for CFDs is less stringent compared to other financial instruments, potentially exposing you to less scrupulous providers who may charge high fees and commissions. Therefore, it is essential to choose a reputable broker with strong industry recognition, such as awards for customer-friendly policies and practices.  

Conclusion 

You’ve made it all the way through this mega guide on trading CFDs – congratulations! 

Before you go, here’s something you might like to know.  

Vantage Markets is an award-winning CFD broker. Our clients choose us not only for our extensive asset and market range but also for our low commissions, tight spreads, and transparent fee structure.  

We’re committed to supporting your trading journey by providing educational blogs, explainers, guides, and news articles to assist you every step of the way.  

Practise CFD trading with a demo account, or sign up for a live account to start enjoying the Vantage advantage today.

References