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XM does not provide services to residents of the United States of America.

What Are CFDs and How Can You Trade Them?

“CFDs offer a broad spectrum of tradable assets and each asset class brings unique opportunities and risks.”

Traders are always looking for profitable and flexible ways to navigate the dynamic landscape of financial markets. CFDs stand out as versatile tools, helping traders access more opportunities and capitalise on different market movements. But what exactly are CFDs?

In this beginner-friendly guide, we will explore everything you need to know including what CFD trading is, how it works, the assets you can trade, and many other important aspects.

Jump to a Section

What Is a CFD?
How Does CFD Trading Work?
Example of A CFD Trade
CFD Trading With Risk Management Strategies
What Kind of Assets Do CFDs Allow You to Trade?
On Which Platforms Can You Trade CFDs?
What Are the Costs of CFD Trading?
How Can You Know If CFD Trading Is Right for You?
What Are the Pros and Cons of CFD Trading?
How Can You Start Trading CFDs?

What Is a CFD?

A Contract for Difference (CFD) is a financial derivative that enables you to trade the price movements of various assets such as stocks, commodities, or indices, without owning the underlying securities.

Are you wondering how you can do this? Let’s break it down. With traditional investment methods, you physically buy and sell the assets. With CFD trading, you enter a contract with your CFD broker to exchange the price difference between an asset’s opening and closing prices.

The two main trading concepts that are facilitated through CFDs are:

Short Selling: CFDs allow traders to go short (sell) when there is a downward trend in the market. This means that CFD traders can profit from both rising and falling prices.
Leverage: CFDs are traded on margin, which enables traders to use leverage, a loan provided by their broker, to control larger positions with a fraction of the invested capital. Traders amplify their position as well as their profits with the use of leverage. However, their losses are amplified as well, which creates the need to have effective risk management strategies in place.

How Does CFD Trading Work?

CFD trading works by speculating on the price movements of various financial assets without owning the underlying securities.

Let’s make an analogy to help you understand it. Imagine you and a friend are interested in the value of a house in your neighbourhood and would like to profit from the change in its price over time. However, you can’t afford to buy the house and you make an agreement to track its price changes instead. If the house’s value increases over time, your friend agrees to pay you the difference between the original value and the new value. If the house’s value decreases, you agree to pay your friend the difference.

In CFD trading, you make a similar agreement with your broker. You don’t buy the actual asset; instead, you agree to exchange the difference in its price from the time you open the trade to the time you close it.

Here is a step-by-step guide to a CFD trade:

Choosing an Asset: First you select the financial instrument you wish to trade. This can be a stock, a commodity, an index, or another asset, depending on what your CFD broker is offering.
Selecting the Leverage Ratio: As mentioned above, CFDs are traded on margin. When selecting the leverage ratio you will be trading with, bear in mind that leverage can amplify your losses. Therefore, choose a ratio that will suit your risk appetite.
Opening a Position: You should decide whether to open a buy (long) or a sell (short) position based on your market analysis. When you click the buy or sell button, you open a trade and enter a contract with your broker.
Monitoring the Trade: Monitoring the price movements of your trade is essential because the market fluctuates. Assess whether to close the position and make a profit if the price moves in your favour, or to close the position and realise a loss if the price moves against you.
Closing the Position: When you decide to close a buy (long) position, you sell the contract back to your CFD broker. Conversely, when you close a sell (short) position, you buy the contract back.
Making a Profit or a Loss: Your potential gains or losses are determined based on the difference between the opening and closing prices of your assets multiplied by the contract size.

Example of A CFD Trade

Let’s examine a hypothetical scenario to make things clearer.

Assume that you believe the price of Tesla stock is going to rise in the short term. Instead of purchasing the shares, you decide to enter into a CFD trade with a broker. You open a long (buy) position with a contract size of 100 shares.

At the time you open the position, the price of Tesla stock is $150 per share and your broker has a 5% margin requirement. In this case, you need to deposit at least $750 to open the position (5% of $15,000). You are therefore controlling a position worth $15,000 (100 shares at $150 per share) with only $750.

The Tesla stock price goes up, and is now worth $155 per share.

You decide to close your position to realise your profit, and you sell the CFD contract worth 100 shares back to the broker at the current price of $155 per share.

Your profit from the trade is calculated as the difference between the closing price ($155) and the opening price ($150), multiplied by the number of shares (100).

Profit = ($155 – $150) * 100 = $500

If Tesla’s stock value were to fall instead, and its price was $145 at the time of closing the trade, then you would incur a loss.

Loss = ($145 – $150) * 100 = -$500

CFD Trading With Risk Management Strategies

As with trading any kind of financial asset, it is essential to have a full grasp of the risks involved in trading CFDs. Identifying the potential risks and implementing effective risk management strategies allows you to limit your potential losses.

Are you wondering how that works? Let’s go back to our previous example and assume that the price of Tesla stock did indeed fall to $145. As we worked out before, that would cause you a loss of $500. Now, let us assume that the maximum amount you were willing to lose was $200. How would you make it so your loss does not exceed that amount?

As a risk management strategy, you set a stop loss order at $148 per share, indicating that if Tesla stock’s price falls to $148, your position will automatically close.

That way, your trade will close before the price of Tesla stock reaches $145 and causes you a loss of $500. The maximum you can lose from that trade will then be the maximum you were willing to lose all along:

Loss = ($148-$150) * 100 = -$200

What Kind of Assets Do CFDs Allow You to Trade?

CFDs offer a broad spectrum of tradable assets and each asset class brings unique opportunities and risks. At XM, for instance, we offer CFD trading on:

Stocks: Stock trading is among the most popular kinds of CFD trading. It allows traders to benefit from the price movements of publicly traded companies’ stocks by going long or short.
Stock Indices: These are groups of companies you can trade based on their overall performance. Stock indices tend to be less volatile than individual stocks because they represent a group of companies, and they can lead to more stable trading opportunities.
Thematic Indices: This new type of CFDs includes groups of companies within a particular industry. You can diversify your portfolio with companies from innovative and high-growth sectors such as AI, Blockchain, and electric cars.
Precious Metals: You can trade CFDs on safe-haven assets such as gold, silver, and other precious metals. These assets have high global demand and offer a lot of speculative opportunities.
Energies: The energy market, which includes oil and gas, is characterised by high volatility, offering traders plenty of speculative opportunities.
Commodities: CFDs also offer the possibility of trading agricultural commodities with physical asset value such as coffee, sugar, wheat, and cacao.

On Which Platforms Can You Trade CFDs?

We offer our traders a range of trading platforms with intuitive interfaces and advanced analytical tools.

XM App: Our award-winning app gives you access to CFD markets with advanced analysis, charts, and free trading signals.
MT4: All our products are available on the MT4 platform. You can use over 50 indicators and charting tools to make the most of your CFD trading.
MT5: You can trade over 1000 CFDs on various assets with MT5. Here, you will have access to advanced tools, more than 80 technical indicators, and over 40 analytical objects.
XM WebTrader: Our native WebTrader is compatible with both MT4 and MT5, and will give you an elevated trading experience straight from your browser.

What Are the Costs of CFD Trading?

The costs involved in CFD trading depend mostly on the broker you choose to trade with.

Spreads

This is the primary way brokers and other financial providers earn their profits. The spread represents the difference between the bid and ask prices of the asset you are trading. At XM, we offer competitively tight spreads that go as low as 0.6 pips. You can read more about it on our designated Spreads page.

Swap fees

Swap fees are charges applied when a position is held overnight. This fee can vary depending on whether the position is long (buy) or short (sell), and the specific rates charged by the broker. Swap fees are calculated and applied daily, and they can affect the overall profitability of long-term trading strategies, making it important for traders to consider these costs when planning their trades.

Commission

Some brokers charge commission fees on the CFDs they offer. At XM, you can trade all the available CFD instruments with no commission.

How Can You Know If CFD Trading Is Right for You?

There are various factors to consider when deciding whether CFD trading is right for you. In fact, some research and self-assessment can go a long way in determining this.

Some of the factors you can assess are:

Your understanding of the financial markets: CFDs are complex instruments. You must have a good knowledge of what the assets you are trading are and what affects them to be able to trade them with confidence.
Your level of risk tolerance: CFD trading is very high risk. You should be aware of and comfortable with the risks involved.
Your investment goals: You should ask yourself whether CFD trading aligns with your short-term and long-term goals.

What Are the Pros and Cons of CFD Trading?

Pros	Cons
Potential for high profit thanks to leverage	Higher risk of loss due to leverage
Ability to profit from both rising and falling markets	Costs associated with spreads and overnight financing charges
Access to a wide range of financial markets and instruments	Overtrading can lead to excessive risk exposure and therefore should be avoided
No ownership of the underlying assets, which simplifies the trading process	Market volatility can result in rapid price fluctuations

How Can You Start Trading CFDs?

Opening an account with a CFD broker is the first step to beginning your CFD trading journey. Make sure you find a regulated broker to open an account with as regulation is crucial when it comes to investor protection. XM, for instance, is a multi-regulated broker and can offer you a secure trading environment with negative balance protection (a safety feature that ensures you cannot lose more money than you have in your account).

Before beginning to trade right away, we recommend you test your strategies with our free demo account, especially if you are a beginner. This is a risk-free way to check if CFD trading is right for you before you trade with real funds.

Here are our few pieces of advice for those who are just starting out:

Conduct thorough market research before opening any positions.
Set stop loss orders to effectively manage your risks.
Keep a watchful eye on price movements and monitor your trades closely.

Ready to Start Trading?

Access a wide range of assets with a global broker by your side. Buy and sell currencies, stocks, indices, commodities and much more on our user-friendly and innovative platforms.

Open an account with XM

Frequently Asked Questions

1. Is it possible to make profits through CFD trading?

Yes, it is possible to make profits through CFD trading, but traders should have a solid understanding of the markets, implement risk management strategies, and use appropriate trading techniques to maximise their chances of success.

2. What is “margin” in CFD trading?

Margin refers to the deposit required to open and maintain a position. It allows you to control a larger position with a smaller amount of capital by using leverage, which is essentially a loan given by your broker. Please note that while margin trading can be attractive due to amplifying a trader’s position and therefore gains, it is also high risk because it amplifies losses as well.

3. What are the advantages of CFD trading over traditional trading?

When compared with traditional trading methods, CFDs are generally considered to have advantages such as:

The ability to trade with leverage and therefore hold positions with less capital (although this also introduces risks)
The opportunity to profit from both rising and falling markets
Access to a variety of markets from the same trading account

However, this is not to say that CFD trading is better than traditional trading as it also has its disadvantages, which we have discussed in the ‘Pros and Cons of CFD Trading’ section of this article. There are plenty of factors to consider when it comes to choosing the type of trading that is right for you.