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 valuable insights you need to effectively engage in CFD trading.  

Key Points 

• Contracts-for-Difference (CFDs) are financial derivatives that allow traders to speculate on price movements of various assets without owning the actual 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 like 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 allow 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 security itself. This may sound strange to the uninitiated, but as you’ll soon learn, trading CFDs could provide certain benefits and advantages not found in conventional securities.  

Furthermore, CFDs are highly flexible and can be applied to a wide range of assets, ranging from shares to 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 – this requires discipline and proper risk management. Additionally, depending on the market or asset chosen, CFD trades can experience high volatility over short periods of time, which beginners or inexperienced traders may find difficult to manage.  

CFD trading has the potential to be highly rewarding, 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 agreement 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 chosen 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 the returns they get 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; this renders CFDs suited to a wide variety of trading strategies and timelines.  

However, sufficient account balance is required to keep positions open through periods of volatility, when prices swing wildly back and forth. 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, inflicting losses on 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 we will also 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 a profitable one.  

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 according to their goals, risk tolerance, and timeline. Here are some commonly used CFD strategies: 

Day Trading 

Day trading seeks to generate returns from a series of CFD trades that are opened and closed within the span of 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 take place across time frames ranging from a few days to several weeks.  

To be successful, swing traders need to be able to spot incoming price swings, and act on them in a timely manner.  

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 being able to identify a long-term price trend, and having the conviction and patience to hold the trade until the price trend runs its course.  

Position trading may sound similar to a long-term buy-and-hold strategy, but the difference is 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 identity confirm or deny price trends.  

Technical analysis in CFD trading  

Technical analysis is an important skill in CFD trading, due to the focus on asset price movements. It involves learning how to read a price chart to discern patterns that could point to potential similarities in 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 highly useful in risk management by indicating appropriate stop-loss and take-profit points in accordance to support and resistance levels.  

• Timing trades: Traders can use technical analysis to check if their market is in overbought or oversold conditions, reducing the risk of opening a trade at an inappropriate time.  

• Confirmation: Technical analysis is particularly useful for certain trading strategies, such as trend following or position trading, as it can quickly confirm an ongoing trend, or warn of 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 be useful in determining trends – a falling moving average indicates a downtrend, while a rising moving average points to 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 aid traders in deciding 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 studies how the MCAD line moves in relation to the signal line, charting bullish (MCAD line moves above zero) or bearish (MCAD line moves below zero) momentum in the market.  

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 stronger the likelihood of a price breakdown and a bearish trend occurring. Meanwhile when the price is increasingly touching the support line, this could indicate a bullish trend is coming.  

Chart patterns 

Candlestick chart patterns constitute a highly popular set of technical indicators, with the appearance of certain patterns pointing to bearish or bullish trends. They are often combined with other technical indicators, which can confirm or deny the indicated trend – this practice offers traders a more well-rounded view of the market.  

Fundamental analysis in CFD trading ^[6]  

The aim of fundamental analysis is to study and understand the various factors that impact the price of a security, stock or asset. Having a firm grasp of fundamental factors helps traders understand price action, and aids in formulating 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 would also include taking a look into the company’s internal factors, such as earnings performance, staff changes and executive level movements. 

When performed with skill, fundamental analysis can enlighten traders to potential trading possibilities while helping to avoid 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 consumption levels and low unemployment may engender bullish price action, while bad news may foster bearish price trends.  

Analysing news and events 

Depending on their nature, news reports, geopolitical developments, and company bulletins can substantially influence asset prices. By keeping track of important news and events, traders can be better prepared to deal with 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 assist traders in making appropriate trading decisions around entries and exits, as well as which strategies to use.  

Getting Started with CFD Trading 

If you’re interested in trying out CFD trading, pay attention to three important 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 have a big impact on 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 unauthorized 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 allows you to trade 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 is borne by the trader. There are also other fees and charges to consider. To ensure you’re paying a fair rate in trading fees and charges, 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 amplifies trading outcomes, whether they be profit or loss. The use of leverage is not mandatory and should only be attempted by highly experienced and well-funded traders.  

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

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 like technical indicators and charting tools, and 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 when markets are experiencing 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 quickness and dependability, as proven by user feedback ratings and community feedback. 

Customer support 

While usually rare, you may encounter issues or difficulties when trading. When this happens, you’ll want a quick solution, and reliable ways to get it. Check to see what 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 and anywhere, enabling faster-than-ever response 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 it is important that your CFD broker provides the risk management tools you need. Having a variety of limits and orders available will enable you to execute more advanced risk management strategies as you develop your trading skills. Similarly, being able to back-test your strategies can be effective in avoiding losses.  

Account types and minimum deposit 

Brokers typically offer different trading accounts aimed at different experience levels, with advanced accounts requiring high minimum deposit. Instead of going for the highest account available, you should start with one that fits your trading budget and risk appetite. 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, causing us to make bad decisions and suffer the ensuing financial impact.  

The fast-paced nature of CFD trading further exacerbates the negative effects of losing control during trading, making it even more important to understand how to keep the negative effects of psychology at bay.  

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), as well as draw up your financial framework to ensure you are trading in a financially responsible manner.  

Drawing up your trading plan is only the beginning. Like any good plan, you will need to refine and tweak your plan as you go along, taking on board your experiences and outcomes. As such, 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, all it takes is one or two bad trades to wipe out your balance, or even 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 with every trade we make – keeping capital-at-risk to under 1% per trade is a good rule of thumb ^[8]. Also helpful is knowing how to make use of orders and stops to limit losses and take profit at the right time. 

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

By the same token, take care to avoid revenge trading at all costs. Encountering an unexpected loss can seem unfair, and in response we may feel justified to make a riskier trade to try to recoup the loss. This can lead to even more mistakes and exacerbate our losses eventually.  

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 large wins, you may well find better results seeking to achieve a steady series of smaller wins.  

Hence it is helpful to embrace patience when trading CFDs, as understanding that it is a game of numbers will help you stay motivated to continually hone your skills and knowledge. Adopting a patient approach is also essential in maintaining risk control and staving off 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 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 just starting out.  

But no matter your experience level, recognise that in trading, learning never stops. Make it a point to keep honing your skills and widening your knowledge and you should see your trading outcomes improving in time.  

Using Leverage in CFD Trading ^[5]  

No discussion about CFD trading is complete without discussing leverage, and that is what 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 may be granted by a broker based on certain qualifying criteria.  

Besides CFD trading, leverage is also commonly found 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, as it is a tool that can be both helpful or 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 $210m giving you a profit of $10 per share. You decide to close out your position for a total profit of $10 x 100 = $1,000.  

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

If the share price falls 

What happens if the trade goes against you, with the share price falling to S$185? In this case, you would have lost $15 x 100 = $1,500. 

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

Leverage vs Non-leveraged Trade 

The effect of leverage can be more clearly shown when comparing these results with a non-leverage trade.  

Recall that with 10:1 leverage, trading 100 shares requires a capital of $2,000. 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 returns (as percentage of capital) on a winning trade	Amplifies losses (as percentage of capital) on a losing trade
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 the returns from a winning trade, allowing you to reap a larger profit with a smaller capital. The implications here is that you can have greater capital efficiency, as you do not need to allocate as much of your capital to achieve the same level of profits.  

You can put the remainder of your trading capital into other trades simultaneously or reserve some spare cash for sudden market opportunities.  

Similarly, leverage also means you can start trading with lower capital, but conversely, this also means if your trade goes against you, your loss – as a percentage of your capital – will be enlarged as well.  

More importantly, traders need to be aware that using leverage may result in a margin call, which will require additional funds to be topped up into the account. This is most likely to happen during market shifts or heightened volatility, when your trade is facing losses that exceed your margin.  

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

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

Are CFDs Right for You? 

CFD Trading: What Beginners Need to Know 

Pros of CFDs	Cons of CFDs
Diverse asset classes available	High risk, fast paced trading
Can place both long and short trades	High degree of complexity, requires good knowledge of 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 summed up above, there are three main benefits offered by 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. 

Besides providing accessibility to popular assets, CFDs are also 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 there are no ownership requirements. 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 securely receive and store your gold holdings. This means having to pay for gold broker storage fees and other middlemen services. However, with gold CFDs, you can simply trade the price action of gold without all these extra considerations.  

Now, on the flipside, CFDs can be demanding in several ways.  

CFDs trades can be fast paced, which can be overwhelming for inexperienced investors who are forced to 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 in order 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 because of our extensive range of assets and markets, but also because of 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 at 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.  

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