Module 1: What Are CFDs? 

1.1 Definition of CFDs 

Contracts for Difference (CFDs) are a type of financial derivative used to trade the price action of an underlying security. It is structured to allow traders to speculate on future price direction, and does not include traditional elements of investing.  

Note that CFDs are not traded on an exchange like conventional securities. Instead, a CFD is a financial agreement between two parties to exchange the price difference between the contract’s opening and closing. This agreement is made between you and your online broker, instead of with another trader.  

Types of CFDs 

CFDs are highly flexible, allowing the trading of virtually any market, asset, or security. Some of the more popular CFDs include: 

• Stock and equity CFDs trade the price action of specified stocks.
• ETF CFDs trade the price action of chosen exchange-traded funds (ETFs).
• Bond CFDs trade the price action of individual bonds or bond ETFs.
• Index CFDs are based on the movement of market benchmarks, such as the Dow Jones Industrial Average (DJIA) or the NASDAQ 100.
• Commodity CFDs, which traders use to speculate on the price of oil, gold, wheat, and other commodities.
• Forex CFDs let traders speculate on movements in currency pairs used in foreign exchange.

1.2 How CFDs Work 

CFDs are advanced trading instruments that require a proper understanding of how they work. Here’s what you need to know:  

1. No Ownership of Underlying Asset or Security 

CFDs do not entail direct ownership of the underlying asset. This means that when you are trading a CFD on Apple stocks, you do not own any Apple shares at all.  

Instead, CFDs simply focus on AAPL’s price action, and your position generates a return or incurs a loss based on how the price of AAPL changes.  

Because ownership is not required, CFDs have advantages and drawbacks, depending on the traded market. For instance, you can trade the price action of WTI crude oil without having to take physical delivery of barrels of oil—a clear advantage for individual retail traders without access to warehousing facilities. 

On the flipside, CFD traders trading equities cannot access shareholding benefits, such as receive dividend payments or vote on company actions. As explained above, no company shares are bought or sold when trading CFDs—the only factor is the change in the share price.  

2. Go Long or Short 

When trading CFDs, you are free to choose whether to take a long or short position (your broker takes the other side of the trade).  

Taking a long position is akin to ‘buying’ the underlying asset or security, and you’d do this if you’re convinced the price will go up. If the price does indeed increase, you can close your long position for a profit. But if the price falls instead, your long position would incur a loss.  

Conversely, if you believe the price will go down, you’d open a short position, in effect ‘selling’ the underlying asset. If the price does indeed go down, you can close your short position for a profit. Similarly, if the price rises instead, your short position would incur a loss.  

Bear in mind that in trading CFDs, there is no actual ownership of the underlying asset.  

Because you can take either position, trading CFDs allow you to potentially profit from the market, no matter whether it is up or down—provided you make the right call. This expands your profit potential relative to conventional investing where you only profit when the market goes up.

3. Place Different Types of Orders 

When trading CFDs with an online broker, you have the ability to place different types of orders for better control over your positions.  

Because orders are essentially instructions that your broker acts on when the right conditions are met, they allow you to maintain control over your trades without having to constantly keep watch over them.  

Here are the basic types of orders to know:  

• Market Orders: Such orders (whether buy or sell) are filled immediately and executed at the current market price.  
• Limit Orders: These orders instruct your broker to buy or sell at a specified price (or better). They are typically used to control the price at which your trade executes.   
• Stop-Loss Order: This is an instruction to buy or sell when the price of the underlying asset hits a trigger price. It is commonly used to limit losses in a trade.  
  • Buy-Stop Order: Entered at a price above the current market price and generally used to limit a loss or protect the profit on a short position. 
  • Sell-Stop Order: Enter at a price below the current market price, which limits a loss or protects the profit on a long position.  

4. Margin Requirements

CFD trades are performed on margin, which means you do not have to put up the full value of the trade. Instead, you only need to place down a percentage of the total value as an initial deposit to start trading.  

This deposit is known as the margin and varies depending on the market you want to trade. Margins are usually represented as a percentage. For example, if a forex CFD requires a 5% margin, and you want to trade a total value of \$10,000, you need only place \$500 as an initial deposit.   

Note that trading on margin means you’re making a leveraged trade. In this case, your leverage is 20x. This has important implications as the result of your trade is calculated on its total value, and not just the initial deposit.  

Furthermore, when trading with margin, you will need to have sufficient cash on hand to top up your account should your position go against you, exceeding your initial deposit. This is known as a margin call. Failing to meet the margin call will result in your trade being closed immediately, with losses allocated to your account.

Leveraged trading allows investors to control larger positions with a smaller amount of capital, amplifying both potential profits—and losses. While this can make trading more accessible and increase the potential return on investment, it also introduces a significant level of risk which can result in losses that exceed your initial capital. 

5. Understanding the Costs

CFD trades are not without costs. Traders have to pay a spread each time the trade is opened or closed. If you’re new to the term, a spread refers to the difference between the bid price and ask price, and it is determined by your broker. 

The broker also charges commissions and other fees, such as swap charges incurred for holding trades overnight.
 
Spreads, fees, and commissions vary according to the markets being traded and between different brokerages. It is important to check with your broker for the exact fees and charges involved before trading.  

Example of Opening a CFD Position 

Here’s a simple example of how CFD trading works.

Let’s say you’re interested in trading XYZ Co, which has been attracting media attention for new breakthroughs. As such, you’re convinced the share price will go up.  

XYZ is currently trading at \$200 per share. You decide to go long on 100 shares. The total value of the trade is \$200 x 100 = $20,000.

Your broker has a margin of 5% for equity CFDs. This means you will need to place an initial deposit of 5% x \$20,000 = \$1,000. 

You place the deposit and enter the trade with your broker. Here are the possible outcomes of your trade. 

• XYZ falls to \$170, meaning a loss of \$30 per share. Your position incurs a total loss of \$30 x 100 = \$3,000. With an initial deposit of \$1,000, your account goes into negative \$2,000. 

• XYZ rises to \$220, meaning a profit of \$20 per share. Your position incurs a total profit of \$20 x 100 = \$2,000. This is added to your initial deposit, bringing your account balance to \$3,000. 

Note that the above example ignores fees and charges.  

1.3 Why Trade CFDs? 

Consider the following benefits that trading CFDs can offer.  

1. Trade Both Long and Short Positions 

When trading CFDs, you can take both long and short positions, letting you potentially profit whether the market is up or down.  

This means you can attempt to profit from trading even during market downturns, instead of simply waiting and watching your portfolio go down.  

In short, trading CFDs is a way to expand your profit potential.  

2. Start Trading With a Smaller Capital  

Because CFDs are traded on margin, you can start trading with a relatively smaller capital.

Returning to our XYZ Co. example earlier, if you wanted to buy 100 shares, you’d need a capital of \$20,000. However, with CFDs, you can go long on the stock for 100 shares with an initial deposit of \$1,000.  

As CFDs require smaller upfront capital, seasoned traders prefer trading them, as they can open and control more positions simultaneously without needing a large capital. This facilitates capital efficiency when trading. 

3. To Hedge Existing Positions 

Assuming your portfolio has shares of XYZ, which have returned satisfactory capital appreciation over the long term. However, like most stocks, XYZ experiences short-term price dips.  

When this happens, you may consider trading CFDs on XYZ, taking a short position to profit when the price goes down. If you make the right call, your CFD trading can generate profits, potentially making up for the loss of value experienced by your XYZ shares.   

When used in this way, CFD trading can be a viable way to hedge existing positions during market volatility.  

4. Trade Larger Position Sizes With Leverage

The use of margin in your CFD trade not only reduces the capital required but also allows you to control a larger position through leverage.

Be cautious when trading with leverage, though. Remember that your exposure is equal to the total value of the trade, and not just your initial deposit. That’s to say, if you use a \$500 initial deposit as margin on a \$10,000 position, your actual exposure is \$10,000.  

1.4 Risks of Trading CFDs 

CFDs offer some unique advantages, but that doesn’t mean they are necessarily suitable for all traders. Here are some reasons why CFD trading may not be for you:

• Due to the use of leverage, it is possible to lose your entire capital—or even more—if you trade moves sharply against you.  
• When a margin call is triggered, it is your responsibility to meet it by topping up the extra amount required. Failing to do so will result in your position being closed, and you will be liable for all losses. 
• Leverage is a double-edged sword that cuts both ways. It can amplify your gains and also your losses. Remember that the outcome of your trade is calculated based on the total value being traded. 
• CFDs trade purely on price action, and do not entail direct ownership of the underlying asset. This means that you will not be entitled to any rights that may come with certain assets. In particular: 
  • Stock CFDs: No dividend payments and no shareholder rights.   
  • Bond CFDs: No coupon payments and no redemption rights at maturity.

Quiz

Module Recap 

• Contracts for Difference (CFDs) are a financial agreement to exchange the difference in the price of an underlying asset between the opening and closing of the contract. 
• CFDs can be traded on any underlying asset. Some of the most popular types of CFDs are equity CFDs, bond CFDs, forex CFDs, commodity CFDs, and index CFDs.  
• In CFD trading, there is no direct ownership, and no actual buying and selling of any asset or security. Only the price action of the relevant market is considered.  
• Traders can use CFDs to go long or short, allowing them to trade in all market conditions. 
• CFD trading is facilitated by the use of different order types such as: 
  • Market orders 
  • Limit orders 
  • Stop-loss orders (buy-stop orders for short positions and sell-stop orders for long positions) 
• CFDs come with a margin requirement, which is usually expressed as a percentage. This allows trading to take place with a relatively smaller capital, but also turns the trade into a leveraged one.  
• The costs involved in a CFD trade usually include the spread, commissions, overnight holding fees, and any other fees or charges pertaining to your broker.
• The advantages of trading CFDs include: 
  • The ability to trade both long and short positions, gaining expanded profit potential.
  • The use of margin which allows trading with a smaller deposit and enabling the control of a larger position (or multiple ones) without high upfront capital.  
  • Potential hedging against market volatility that impacts your existing holdings.  
• On the flipside, CFD trading comes with certain risks, including: 
  • The possibility of losses exceeding your capital due to leverage.
  • Margin calls, which requires timely topping up of additional funds—failing which could result in severe losses.
  • Leverage can amplify both profits and losses.
  • No direct ownership of underlying assets, which means no rights or benefits such as dividend payouts and voting rights.