CFD trading has advantages that have made it very popular among traders, especially in the past 10 years. CFDs give investors and traders the opportunity to trade without actually owning any asset. This simple security is calculated by price movements of assets between the points of entry and exit of a trade. Only the price change is considered and not the asset value.
This happens through contracts established between broker and client and requires no futures, commodity, forex, or stock exchange.
How CFD Trading Works
CFD trading works in five simple steps:
Step #1: The first step is to choose the instrument to trade on. Online brokers offer a wide range of instruments across asset classes such as precious metals, commodities, currency pairs, indices, and so on. Clients can trade CFDs across markets such as commodities, bonds, forex, and indices.
Step #2: The next step is to determine if you would like to buy or sell. If you feel that the price of the underlying asset is going to rise, the better option is to buy. If you feel that the price is going to fall, you have to sell.
Step #3: Now you have to decide how many CFD units you would like to trade. CFD value changes according to the instrument traded.
Step #4: Risk management is the most important step, and online brokers offer a wide range of risk management tools such as stop loss orders. To be on the safest side, traders can get a guaranteed stop loss order, which guarantees to close your trade at the specified price irrespective of market gapping or volatility. Traders have to pay a premium for this service, but they will get a refund if their trade succeeds and the guaranteed stop loss order is not required after all.
Step #5: If a take profit order or a stop loss order does not automatically close your trade, you have to close it manually when you feel that the time is ripe.
Let us now try to understand the above with the help of an example. A trader decides to purchase 1000 share CFDs that are trading at 1599/1600p. The trader feels that the price will rise and that he will be able to make a profit.
Since the margin rate is 5%, the trader has to deposit only 5% of the actual position value, which will be $800. If the price rises as the trader predicted and becomes 1625/1626p, the trader can close the position by selling the trade at the new sell price of 1625p. In case of a successful trade, the profit made would be $250.
On the other hand, if the trader’s prediction turned out to be wrong and the price fell to 1549/1550p, the trader may feel that the price will continue to fall. In this case, he can sell the shares to cut his potential losses at the new sell price of 1549p. But he will have lost $510.
CFD Trading Regulations
As it is a highly leveraged market that attracts a large number of traders with promises of huge and fast profits, the CFD market has to be regulated. While hunting for the right CFD broker, traders have to check for a regulator’s seal of approval.
Financial laws worldwide require brokers to be authorized and regulated by a regulatory body. If there is no regulatory body overseeing the market, brokers can easily distort the markets for their benefit and impoverish their clients. You can be sure that only a regulated broker can provide an accurate reflection of price movements in the CFD market.
The following is a list of various regulatory bodies according to country:
- Australia – The regulatory body in Australia is the Australian Securities and Investment Commission (ASIC).
- Canada – Canada has a number of regulatory bodies such as the Canadian Investor Protection Fund (CIPF), Investment Industry Regulatory Organization of Canada (IIROC), and the Ontario Securities Commission (OSC).
- Cyprus – The regulatory agency in Cyprus is the Cyprus Securities and Exchange Commission (CySEC).
- Denmark – In Denmark, it is the Danish Financial Supervisory Authority (Danish FSA).
- New Zealand – NZ has a bunch of financial regulators such as Financial Markets Authority (FMA), Financial Services Complaints Limited (FSCL), and the Financial Service Providers Register (FSPR).
- United Kingdom – The UK also has a bunch of regulators such as the UK Financial Services Authority (FSA UK), the Financial Conduct Authority (FCA), and the Financial Services Compensation Fund (FSCS).
Understanding CFD Risks
While trading CFDs, you have to understand that you are taking a number of risks, some of which are as follows:
To profit in CFD trading, traders have to accurately predict price movements. Even expert traders can fail in this because of unexpected developments and changes in government policies and market conditions. Even the slightest change can have a disastrous result on trade returns. Providers may demand second margin payments, and if traders cannot meet these margin calls, providers may close the position or traders may have to sell, which results in huge losses.
Countries that have legalized CFD trading have strong laws in place to protect investors and traders from CFD providers. The law requires providers to maintain investor funds separately to avoid hedging. But the law may not prevent providers from pooling client funds into the same or many accounts.
When a CFD trade is bought, providers withdraw the initial margin and can make second margin calls in the future. If clients fail to meet these calls, providers may draw from pooled accounts. This may have a huge impact on trade returns.
Companies that provide assets in financial transactions are called counterparties. When traders buy or sell CFDs, the contract is the only asset issued by the CFD provider. Traders, therefore, get exposed to the other counterparties of this provider. Failure to meet financial obligations on the part all or any of these counterparties have an adverse impact on asset value.
Traders can actually lose more than the funds deposited in CFD trading. This is because of high leveraging, which enables traders to access the CFD market by depositing only a percentage of the total trade value. If the price moves in traders’ favor, they can make a huge profit. If it doesn’t, the losses could be more than the amount deposited.
Risk vs. Profit – How to Minimize CFD Trading Risks
As many as 76% or even more CFD traders lose their deposits because of the heavy risks associated with CFD trading. In fact, the risks increase with the amount of profit traders wish to generate.
However, there are a few ways to minimize these risks and make the most of your CFD trading activities:
- Develop an effective trading plan – Trading plans can help traders to not only define their trading goals, but also achieve them.
- Go slow – Leveraged products are highly risky; so traders should spend a lot of time getting used to them.
- Learn about the markets – Traders should spend a lot of time learning everything about the markets they wish to trade on.
- Closely monitor open positions – If you are unable to manually monitor open positions, use apps to do so. You can also establish price alerts so that you are instantly alerted as soon as a price is reached.
- Use limits and stops – Limits and stops can protect traders against unexpected price movements in the market. Brokers offer a number of risk management tools, which traders shouldn’t hesitate to use.
- Continue to Educate Yourself – In the trading world, education never stops. Traders should, therefore, never consider that they know it all and that there is nothing more to left to learn.
Best Brokers for CFD Trading
We have identified the following brokers as the best for CFD trading:
- A-Markets has been delivering the best CFD trading services from 2007. Some of its highlights include regular promotions and bonus offers, banking methods with zero commission, up to 1:1000 leverage, and spreads that start from 0.2p. In 2013, it became a Category A member of the Financial Commission.
- XM Forex offers forex and CFD trading on commodities, stocks, metals, indices, and energies. Traders can choose from platforms such as XM WebTrader, MT4, and MT5. Some of the advantages of CFD trading at XM Forex are features such as video tutorials, personal account managers, free daily technical analysis, and 24/5 live support.
- FXTM – Forex Time is a licensed and regulated online FX broker, which offers over 250 trading instruments and a wide range of accounts. In addition to running high quality promotions and contests, it maintains clients’ funds in separate accounts at top-tier banks in the European Union.
- IQ Option offers asset classes such as options, ETFs, forex, crypto, commodities, and CFDs on 167 stocks with up to 20x leverage. It is also a social trading platform that encourages traders to share their ideas and experiences and be part of the community.
- Pepperstone is an ASIC regulated online broker, which has won multiple industry awards. It offers spreads that start from 0.9, over 80 trading instruments, 11 trading platforms, minimum deposit of $200, and leverage of up to 1:500.
- Alpari has been on the market for 20 years. In addition to offering excellent trading conditions, it offers excellent forex education. Recently, the broker introduced contests and bonus offers. Over 2 million clients have registered at Alpari, which operates under three international financial licenses. The broker is famous for its PAMM services, MetaTrader platform, and cashback program.
- Libertex offers an excellent cross-platform trading experience, a simple and user friendly trading platform, trading signals, market analysis, and the best possible security. It is a regulated and authorized broker, which offers leverage of up to 1:600 for professional clients and 50% discount on commissions for new traders.
- 24Option offers CFD and forex trading on an advanced and browser-based trading platform. Traders can start their journey at 24Option.com with a bonus of up to 50%. One of the most special features of 24Option is that it offers CFD trading on a wide range of cannabis stocks.
CFD Trading FAQs
Q1: How much can you make?
A: Your CFD trading profits depend on factors such as the size of your trading account and the size of your trade. Expert CFD traders can actually make a living out of CFD trading. It all depends on how well a trader can handle risks and the trading strategies he/she implements.
Q2: How much can you lose?
A: If your CFD provider caps your loss, you may lose exactly as much as you invest. Or you may lose much more than you deposit. Theoretically speaking (it may never happen), you could lose an entire fortune trading CFDs if you are careless.
Q3: Is CFD trading legal?
A: CFD trading is legal in many countries such as Australia, UK, the European Union, South Africa, New Zealand, Canada, Switzerland, and Japan. CFD trading is illegal in the US and in many Asian countries, but there are no laws to prevent traders from signing up at online brokers and trade CFDs.
Q4: Do I have to pay taxes on my CFD profits?
A: If you live in a country that has legalized CFD trading, you will definitely have to pay taxes on your CFD profits.
Q5: Does Islam permit CFD trading?
A: Islam does not permit CFD trading as traders do not own the product, but only speculate on price movements between entry and exit point. Islam also does not permit leveraging, which is part of CFD trading.
CFD trading is an adventure full of risks and certainly not for those faint of heart. Trade only if you have money that you can afford to lose. Understand all the risks associated with CFD trading, and once you are ready, you can sign up at one of the brokers we recommend.