Contract For Difference

What is a CFD?

CFD stands for Contract For Difference, which is a derivative product that is traded, where you profit from changes in the prices of stocks and shares.

For example, if you buy a CFD on a stock that is $5.00 and the price rises to $5.50, then you profit from that change in price. So if you bought 1000 CFDs of that stock, then your profit is $500, minus costs. That is, the value of the CFDs mirror the underlying stock prices, and you can profit on this movement. You can just as easily short sell CFDs as well, and therefore profit from falling markets.

The reason why CFDs are a popular trading product, is that they are traded on leverage, and the leverage is typically 10 to 1.

With some providers this is 20:1.

What this means is that a trader with a small float can make larger profits from trading the stock market by using CFDs. All the trading results are magnified however, so if your system produces a certain sized loss in 1 year with no leverage, then this will be multiplied if you do use leverage.

If you're new to CFD trading, see this CFD trading tutorial that will actually go through an example trade, including the transaction costs of CFD trading, position sizing, and definitions of order types.

So the advantages to CFD trading are:

Leverage

This increases the profitability of a CFD trading system by ten to twenty fold.

For example, if the margin requirement by the CFD provider is 10%, this means that with $5000 of funds, you can buy $50 000 worth of CFDs (10 to 1 leverage). If you have a system that without leverage produces a certain return and drawdown percentage, then with leverage, you will produce magnified profit and drawdown.

Go short CFD as well as long

You can with ease go short on CFDs as well as long.

Depending on your CFD broker or provider, you may be able to short the majority of their CFDs, with other providers, you can only short a portion of their CFDs. Being able to do short trades significantly increases the profitability of many trading systems, as you’re able to profit from both falling stock prices, as well as rising stock prices. You can profit from a bear market, not just during a bull market.

Trade shorter time frames

Because of the leverage available, and the ability to short CFDs, you can profit from smaller moves in the underlying stock prices.

This means that you can profit without needing to hold onto positions for a long time frames. For example, you can trade systems where you’re in trades for a few days to a few of weeks, instead of needing to be in positions for many months with some stocks to get a decent return. The growth in your equity curve is therefore smoother and more consistent.

Automatic stop losses

Unlike stocks, you can place automatic stop losses for CFD positions on your CFD trading platforms. This can help in two ways.

Firstly, they will allow you to exit a trade automatically “intraday”, rather than looking at the end of the day to see if the stock price has gone past your stop loss, before exiting the next day. This often improves the profitability of systems as it avoids this kind of slippage. Another words, it doesn’t let your losses run, which is important. Secondly, automatic stop losses make it easier for traders to follow a mechanical system, as the exits are done automatically, not at your discretion, which again, will improve your profitability, assuming you’re trading a profitable system.

You can place all your orders in the evenings

For many people who work, trying to place trades when the market is open, and exit them during the day can be near impossible.

So this is another reason why CFD trading is the instrument that makes it possible for people to trade a profitable system, by trading only in the evenings.

With many CFD providers, you can place all your trades in the evenings when the market is closed (in fact usually anytime of the day or night). That is you place your orders to enter a CFD, as well as your "if done" stop loss order, all at one time, and you won't need to look at the computer screen during the day to trade. The whole trading routine will take less time.

Click here for a complete list of CFD trading articles, and also for the latest CFD trading news.

Also, you can also see this blog on CFD Trading.