A Brief History of CFD Trading
CFD trading dates back to the late 1970s and early 1980s when financial derivatives first emerged as a means for traders to speculate on the price movements of financial assets.
CFDs quickly gained popularity among professional traders because they provide a flexible and cost-effective way to trade a wide range of financial assets. In the following years, the development of online trading platforms made CFD trading accessible to retail traders, and since then, the industry has grown rapidly.
What is the difference between CFD trading and traditional trading?
The main difference between CFD trading and traditional trading is that when you trade a CFD, you are speculating on a market’s price without taking ownership of the underlying asset. With traditional trading, you take ownership of the underlying asset and may receive dividends on a regular cycle.
There are other differences between the two types of trading, with some that give CFD trading an advantage and some that make CFD trading more risky.
What are the benefits of trading CFDs?
CFDs benefit from several features that make them valuable to individual traders:
Accessibility: CFD trading is often more accessible than traditional trading as it requires a smaller initial investment. For example, some CFD brokers have minimum deposit requirements of only 1 USD, which makes it easier for smaller investors to enter the market and start trading.
Leverage: Most CFD trading is leveraged trading, which means that traders only have to put up a small amount of capital to gain exposure to a large trading position. This is accomplished through the use of borrowed funds from the broker. For example, if a broker offers leverage of 20:1, the trader only has to put up 5% of the value of the trading position and can multiply his money 20 times over. Leverage can increase your profits, but it can also significantly increase your losses.
Profit from falling and rising markets: You can use CFDs to speculate that the price of an asset will rise (going “long”) or that it will fall (going “short”). Because CFDs are an agreement to pay the difference in the price of an asset, going short is very simple. You simply open a “sell” position and close it again once the price has fallen enough for you to make a profit.
Convenience: You can trade CFDs in many different assets without taking physical delivery, saving on storage, security and transportation costs. For example, you can trade CFDs in gold online and simply profit from price changes in the commodity without worrying about how you will store it securely.
Flexibility: You can close a position at any time during the trading day. That means you can hold a position for as long as you want, be it seconds, minutes or hours. You can even hold a position overnight, although there will be a charge for doing so. Many brokers also offer various options when it comes to trade size, allowing a wide range of traders to access the market.
Ability to hedge: Most people are familiar with the term “hedging your bets” and understand that it involves offsetting risks. Well, it means precisely the same thing in the financial world and is derived from the age-old idea of using a hedge – or fence – as a means of protection. In this instance, you can use CFDs to offset your trading positions by balancing trades in case your beliefs about whether those initial positions are likely to rise or fall prove wrong.
Exposure to a vast range of financial assets: You can use CFDs to gain exposure to thousands of underlying financial instruments worldwide from just one trading platform.
Why is CFD trading risky?
Like any other type of financial trading, CFD trading involves a high degree of risk. Some of the key risks associated with CFD trading include the following:
Market volatility: CFD markets are known for their volatility. Markets are influenced by political and economic events, and sudden shifts in these events can lead to rapid and substantial price movements.
Volatility can widen spread and costs: Severe volatility in markets or a particular product can cause brokers to widen spreads, affecting the prices paid by the trader when entering and exiting positions, potentially negatively impacting trades and increasing losses.
Leverage: CFD traders can use high levels of leverage to gain access to large trading positions, and while this can magnify potential gains, it can also magnify losses.
Constant monitoring: You must always be alert to possible changes in your position. Market volatility and rapid price changes – which could arise outside regular business hours if you are trading international markets – can cause the balance of your account to change quickly.
Lack of regulation: There are many unregulated CFD brokers in operation, which increases the risk of scams and unethical practices by some market participants.
Liquidity risk: CFD markets can experience periods of low liquidity, resulting in difficulty exiting a trade at an acceptable price.
Lack of ownership: Because you don’t own the underlying asset, you can’t gain from the benefits of ownership, such as the income provided at set periods by shares or bonds (like dividends).
It’s important for forex traders to educate themselves on the risks involved in CFD trading and to develop a solid risk management plan to help mitigate these risks.
What is the role of a broker in CFD trading?
A CFD trading broker is an intermediary between traders and the financial markets. The primary role of a CFD broker is to provide access to a wide range of financial instruments, such as stocks, indices, commodities, and currencies, that traders can buy or sell using CFDs.
The broker also provides traders with the platform, tools, and resources needed to analyse market trends, place trades, and manage their investments. In addition, brokers offer traders leverage to benefit from larger trading positions with only a small amount of capital. The broker may also provide other services, such as educational resources and customer support.
What CFD financial instruments can I trade?
Below are the most common financial assets you can gain exposure to via CFDs.
Currencies (Forex): Currencies are traded in pairs against each other, such as the US dollar against the euro. There are hundreds of currency pairs available to trade via CFDs. The global market is vast, with around $6.6 trillion traded daily in foreign exchange markets.
Shares: You can buy CFDs in most major global stocks. Like the forex market, the global share market is vast so you can choose from a huge number of highly liquid shares.
Indices: These provide a representation of an overall market. For example, a collection of different stocks are grouped together, and an average price is taken for all of these stocks, creating the price of the index. Well-known examples include the Dow Jones and the S&P 500 in the US.
Cryptocurrencies: You can trade various popular cryptocurrencies with leverage, from Bitcoin and Ethereum to TRON and NEO. The global cryptocurrency is growing rapidly, but prices are highly volatile, magnifying the potential for large profits and losses. One of the key advantages of cryptocurrency CFDs is that you don’t own the underlying assets, preventing the risk of loss due to a cybersecurity breach.
Commodities: Using CFDs, you can gain exposure to a diverse range of commodities, from oil to gold to copper. Commodities are hugely liquid and are subject to a range of influences, from global supply and demand, to political announcements and the economic cycle.
Bonds: Effectively, IOUs issued by governments, companies and other entities, the bond market, also known as the fixed income market, because of the regular set payments these instruments provide, is another of the world’s biggest financial markets.
Interest rates: You can use CFDs to bet on the future direction of interest rates in a wide range of major global markets. The advantages of interest CFDs include relatively attractive margins of 20% and low spreads compared to other products.
Common CFD Trading Strategies
Once you have signed up with a broker, you should always open a demo account to practice trading on their trading platforms in real market conditions and form a trading strategy.
A trading strategy outlines the rules for entering and exiting a trade and includes creating a risk management plan to prevent high losses. It is crucial to thoroughly research and test a strategy before using it in live trading. There are many different CFD trading strategies, and traders often use a combination of technical and fundamental analysis to inform their decisions.
Some common strategies include:
- Trend following: This strategy involves identifying the direction of the market trend and taking trades in the same direction.
- Breakout trading: This strategy involves entering a trade when the price of an asset breaks out of a defined range, with the expectation that the price will continue to move in that direction.
- Swing trading: This strategy involves taking advantage of short-term price movements, typically holding positions for a few days to a week. Swing traders use technical analysis and trend-following indicators to identify and enter trades, with the goal of riding the price swings for maximum gain.
- Scalping: This high-frequency trading strategy involves taking advantage of small price movements in short time frames, such as a few minutes or seconds.
- Day trading: Day trading involves opening and closing positions within the trading day. Many traders think that day trading and scalping are similar, but day traders open and close substantially fewer setups than scalpers.
- Position trading: This is a longer-term trading strategy that involves holding positions for several weeks or months.
Risk Management Strategies for CFD Trading
Creating a successful risk-management strategy takes time, education, and patience, but there are a few simple ways to minimise your risk:
- Use low leverage levels: Smaller amounts of leverage applied to each trade affords more breathing room and help traders avoid larger capital loss. A highly leveraged trade can quickly deplete your trading account if the trade goes against you.
- Setting stop-losses: A stop-loss is an automated order placed with a broker to buy or sell once the CFD instrument reaches a certain price. A stop-loss order limits a trader’s loss on a trade.
- Diversification: Diversify your portfolio by spreading your trades across different markets, instruments, and timeframes to help reduce your overall risk exposure.
- Position sizing: It is important to only risk a small percentage of your trading capital on any given trade. This can help reduce the impact of individual losses on your overall portfolio.
- Staying up-to-date: Keeping abreast of market news and economic events can help you stay ahead of potential market movements and make informed trading decisions.
- Emotional control: Emotional control is key in trading, as fear and greed can often drive poor decision-making. Stick to your trading plan, and keep calm and focused to make more rational and effective trading decisions.
Forex Risk Disclaimer
Trading Forex and CFDs is not suitable for all investors as it carries a high degree of risk to your capital: 75-90% of retail investors lose money trading these products. Forex and CFD transactions involve high risk due to the following factors: Leverage, market volatility, slippage arising from a lack of liquidity, inadequate trading knowledge or experience, and a lack of regulatory protection. Traders should not deposit any money that is not considered disposable income. Regardless of how much research you have done or how confident you are in your trade, there is always a substantial risk of loss. (Learn more about these risks from the UK’s regulator, the FCA, or the Australian regulator, ASIC).
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Editorial Team
Chris Cammack
Head of Content
Chris joined the company in 2019 after ten years experience in research, editorial and design for political and financial publications. His background has given him a deep knowledge of international financial markets and the geopolitics that affects them. Chris has a keen eye for editing and a voracious appetite for financial and political current affairs. He ensures that our content across all sites meets the standards of quality and transparency that our readers expect.
Alison Heyerdahl
Senior Financial Writer
Alison joined the team as a writer in 2021. She has a medical degree with a focus on physiotherapy and a bachelor’s in psychology. However, her interest in forex trading and her love for writing led her to switch careers, and she now has over eight years experience in research and content development. She has tested and reviewed 100+ brokers and has a great understanding of the Forex trading world.
Ida Hermansen
Financial Writer
Ida joined our team as a financial writer in 2023. She has a degree in Digital Marketing and a background in content writing and SEO. In addition to her marketing and writing skills, Ida also has an interest in cryptocurrencies and blockchain networks. Her interest in crypto trading led to a wider fascination with Forex technical analysis and price movement. She continues to develop her skills and knowledge in Forex trading and keeps a close eye on which Forex brokers offer the best trading environments for new traders.