In this article, you'll learn:
- What CFDs are and the benefits and risks of trading them
- What leverage is and how to use it in practice
- What makes CFDs so popular
The term CFD stands for contracts for difference.
A contract for difference creates, as its name suggests, a contract between two parties on the movement of an asset price.
There are several key features of CFDs that make them a unique and exciting product:
- CFDs are a derivatives product
- CFDs are leveraged
- You can profit and incur losses from both rising and falling prices
- We offer contracts for differences on over 1500 global markets, including indices, shares, currencies, commodities, and ETFs
CFDs are a derivatives product
This means that you don’t actually own the underlying asset - you’re simply speculating on whether the price will rise or fall.
Let’s take stock investing as an example. You’d like to purchase 10,000 shares of Barclays and its share price is 280p, which means that the total investment would cost you £28,000 - not including the commission or other fees your broker would charge for the transaction. In exchange for this, you receive a stock certificate, legal documentation that certifies ownership of shares. In other words, you have something physical to hold in your hands until you decide to sell them, preferably for a profit.
With CFDs however, you don’t own those Barclays shares. You’re simply speculating, and potentially profiting, from the same movements in share price.
CFDs are leveraged
This means you gain a much larger market exposure for a relatively small initial deposit. In other words, your return on your investment is significantly larger than in other forms of trading.
Let’s go back to the Barclays example. Those 10,000 shares of Barclays are at 280p, costing you £28,000 and not including any additional fees or commissions.
With CFD trading however, you only need a small percentage of the total trade value to open the position and maintain the same level of exposure. Let’s suppose that XTB gives you 10:1 (or 10%) leverage on Barclays shares, so you would only need to deposit an initial £2,800 to trade the same amount.
If Barclays shares rise 10% to 308p, the value of the position is now £30,800. So with an initial deposit of just £2,800, this CFD trade has made a profit of £2,800. That’s a 100% return on your investment, compared to just a 10% return if the shares were bought physically.
The important thing to remember about leverage, however, is that while it can magnify your profits, your losses are also magnified in the same way. So if prices move against you, you may be closed out of your position by a margin call or have to top up your funds to keep it open - so it’s important to understand how to manage your risk.
If Barclays shares declines 10% to 252p, the value of the position is now £25,200. So with an initial deposit of just £2,800, this CFD trade has made a loss of £2,800. That’s a -100% return on your investment, compared to just a -10% return if the shares were bought physically.
What markets can you trade CFDs on?
We offer contracts for difference on over 1500 global markets and multiple asset classes, all with the ability to utilise leverage and go both long or short including:
- FX
- Indices
- Shares
- Currencies
- Commodities
You can profit from both rising and falling prices
If you believe the price of an asset is going to rise, you go long or ‘buy’ and you’ll profit from every increase in price.
If you believe the price of an asset is going to fall, you go short or ‘sell’ and you’ll profit from every fall in price. Of course, if the markets don’t move in the direction you expect, you’ll suffer a loss.
So, if you believe for example that Apple’s share price will fall in value, you simply go short on Apple share CFDs and your profits will rise in line with any fall in price below your opening level. However, should Apple’s share price actually rise, you would suffer a loss for every rise in price. How much you profit or lose will depend on your position size (lot size) and the size of the market price movement.
The ability to go long or short along with the fact that CFDs are a leveraged product makes it one of the most flexible and popular ways of trading short term movement in financial markets today.
