Warning: Trading CFDs is high-risk and you may end up losing more than your initial deposit. Please make sure you fully understand the risks involved before you start CFD trading.

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How CFDs work

If you have experience in buying stocks and shares then you shouldn’t find getting the hang of CFDs too difficult. That said, it is worthwhile thoroughly researching CFDs and how they work before you embark on your CFD trading. CFDs have some unique qualities compared to other forms of trading, and it is important to understand them before you begin.

Essentially, Contracts for Difference (CFDs) allow traders to make money from share-price movement without actually having to own the share itself. This is enabled by entering in to a contract with a CFD broker, in which you commit to switch the difference in the value of the shares between the opening and the closing of the CFD. The profit a trader makes depends on the direction in which the share value moves.

Short-selling

Perhaps the most striking feature of CFDs compared with traditional trading is the ability to ‘short sell’. Short selling, is betting on a share price to fall and making a profit when it does so. In practice, this means selling an asset that you don’t actually own, intending to buy it back in the future at a lower price. A trader then keeps the difference between the two prices.

With CFDs you can short-sell just as easily as conventional buying trades. When you open a trade you normally just select ‘sell’ instead of ‘buy’ to take a position on a market fall. This is also sometimes called ‘going short’ and ‘shorting’.

Shares can be ‘short-sold’ by borrowing them from a third party - often a broker - and then sold. This borrowing happens behind the scenes, and isn’t something the trader needs to worry about, it is done automatically for them by the broker.

Financing on margin

The other main feature of CFDs is they way in which they are financed. CFDs are a margined product, that is, you trade with borrowed money to increase your profits. In essence, this means you only need to have a small proportion of the value of the trade. This allows traders to stake larger amount of money on a prediction and therefore, if correct, make a larger profit. However, by extension, this also increases the amount a trader is liable to lose if they are incorrect in their prediction. This makes margin trading a high risk/high regard strategy, and should be used carefully to ensure that your losses to not outweigh your gains.

CFD Brokers offer different degrees of ‘leverage’, that is the factor by which you can trade on margin. The higher the leverage, the high the value of a CFD position you can take in any particular trade. Usually a trader will have to put around 5-20% of the value of a trade as a deposit. The deposit is important for two reasons:

  1. To ensure traders only trade within their financial capacity, and to cover unexpected losses on a trade.
  2. Margin is a particularly dangerous tool when markets are volatile. In such times the amount brokers will ask for a deposit in a trade is often larger.

There are no ifs and buts when it comes to the deposit, you will only be able to open a position if you have the finances to cover the deposit in full before you initiate the trade. WeCompareBrokers offer you the possibility to compare different leverage values, so you know how much you may be able to factor your trades up by.

Commission

CFD Broker commission is a highly competitive area, with pretty much all CFD brokers coming in at around the 0-0.2% rate, or offering a flat rate at, for example, £25. This amount is usually fixed for both buying and selling. Some brokers may also impose a minimum commission threshold amount of, for example, £10, that you will have to pay no matter how small the trade to cover the broker’s costs.