Contracts for difference (CFDs) are financial instruments that allow traders to speculate on the price movements of various markets, such as indices, forex, commodities, and shares, without owning the underlying assets. CFDs are a type of derivative, meaning their value is derived from the price of these underlying assets.
CFD traders benefit from the ability to use leverage, as well as the flexibility to speculate on both rising and falling markets. However, leverage can magnify losses as well as gains, with market volatility and potentially overnight holding costs also posing significant risks for traders.
As a new trader, it is thus important to understand both the advantages and the risks associated with CFD trading before you start trading with a live account.
Advantages of CFD trading
Trade on both rising and falling markets
With contracts for difference, you can trade on the price of a product going down as well as up, so you can try and benefit from selling (shorting) as well as buying opportunities. Many investors use CFDs as a way of hedging their existing portfolios through periods of short-term volatility.
Efficient use of your capital
One of the key advantages of CFD trading is that you can trade on margin, which gives you 'leverage'. This means you can trade without having to put down the full value of a position. As your money is not tied up in one transaction, you can use it for other investments. Read more about trading with leverage.
For example, to buy the equivalent of 10,000 telecom company share CFDs with CMC Markets, you may only need to deposit 20% of the total position value that you might have to pay if you were buying physical shares from a stockbroker.
If each share cost $1.50 then you would only need to deposit $3000 of position margin with us (20% of $15,000 = $3000) plus the applicable commission.
Potential risks of CFD trading
CFDs are a leveraged product
Leverage gives you exposure to the markets by depositing just a percentage of the full value of the trade you wish to place. This means that while you could make a potential profit if the market moves in your favour, you could just as easily make significant losses if the trade moves against you and you don't have adequate risk management in place. This is also known as margin trading.
In order to place a CFD trade, you need to deposit a percentage of the total value of the position, known as position margin. If you buy $1000 worth of CFDs and the margin rate for the applicable tier is 20%, you only need to pay a position margin of $200. However, your exposure is the same as if you had purchased $1000 worth of the shares at face value. This means that any move in the market will have a greater effect on your capital than if you had purchased the same value of shares.
Learn more about calculating CFD margins.
Risk of account close-out
Market volatility and rapid changes in price, which may arise outside normal business hours if you are trading international markets, can cause the balance of your account to change quickly. If you do not have sufficient funds in your account to cover these situations, there is a risk that your positions will be automatically closed by the platform if the balance of your account falls below the close-out level (as shown on the platform).
You should continuously monitor your account and deposit additional funds or close your positions (or a portion of your positions) so that the funds in your account cover the total margin requirement at all times. The information icon within the main account bar at the top of the CFD trading platform will detail all your account information, including the close-out percentage level.
Account close-out example:
If the current close-out percentage level is 50% and you have four trades open that each require $500 worth of position margin, your total position margin requirement will be $2000. If your account revaluation amount then drops to less than 50% of the total margin requirement, in this case $1000, some or all of the trades constituting this position may be closed out, potentially at a loss to you.
The account revaluation amount is the sum of your cash and any net unrealised profit or loss (as applicable), where net unrealised profit or loss is calculated using the level 1 mid-price.
Market volatility and gapping
Financial markets may fluctuate rapidly and the prices of our instruments will reflect this. Gapping is a risk that arises as a result of market volatility. Gapping occurs when the prices of our instruments suddenly shift from one level to another, without passing through the level in between. There may not always be an opportunity for you to place a market order or for the platform to execute an order between the two price levels. One of the effects of this may be that stop-loss orders are executed at unfavourable prices, either higher or lower than you may have anticipated, depending on the direction of your trade. You are able to limit the risk and impact of market volatility by applying boundary order or guaranteed stop-loss order.
Holding costs
Depending on the positions you hold, and how long you hold them for, you may incur holding costs. These holding costs are applied to your account on a daily basis if you hold positions on certain instruments overnight past 5pm New York time. In some cases, particularly if you hold positions for a long time, the sum of these holding costs may exceed the amount of any profits, or they could significantly increase losses. It is important that you have sufficient funds in your account to cover your holding costs.
CFD trading carries a high level of risk to your capital compared to other kinds of investments, and prices could move rapidly against you. Therefore, CFD trading may not be appropriate for everyone and we recommend that you understand the risks, and seek independent professional advice if necessary, before deciding whether to start CFD trading. Read an overview of our CFD costs. You can also sign up for a CFD demo account before opening a live trading account.