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Let’s be real - if traditional trading were perfect, traders wouldn’t be looking for alternatives. Fortunately, CFD is a great option that has some serious advantages. It solves many of the problems that you’d usually encounter with traditional trading. However, it isn’t flawless either.
So, what makes it better yet not perfect? To understand this better, let’s learn what makes CFDs a strong alternative, why more traders are making the switch, and a few things to keep in mind.
What is CFD Trading?
CFD stands for Contract for Difference. It is a trading instrument and a type of derivative that allows a trader to speculate on the price movements of assets, ranging from forex and crypto to traditional stocks and indices, without actually owning the underlying assets.
For example, traditionally, to sell Tesla stocks, you must first own them. You need to enter the market and purchase at least a single stock at whatever price it is at. As of now, the cost of the stock is $293.04. This means a bare minimum of $293.04 is required to start trading.
This limitation does not exist within CFD trading. Here, you can use what is called leverage. It allows you to control a larger trade with a smaller deposit. For example, with 10:1 leverage, a $1,000 deposit lets the trader trade $10,000 worth of an asset. While this certainly boosts potential profit and reduces the barrier to entry, it also increases risk. Why? Because small market moves can lead to big losses, so tread cautiously.
Moreover, it makes it possible to trade no matter if the market is bullish or not. How is that possible? Well, when you open a CFD trade, you enter a contract with your broker. If you buy (go long), you profit if the price rises. If you sell (go short), you profit if the price drops.
Your profit or loss is based on the difference between your entry and exit price. However, we’ll discuss that in depth further below.
CFD Trading vs. Normal Trading: What’s the Difference?
Both are trading instruments that allow you to participate in the financial markets. While they are fairly similar, major differences separate them. The main difference is the concept of ownership.
As explained in the example above, you must own a stock for normal trading. It needs to be yours, which means there is ownership involved. You can hold stocks long-term, collect dividends, and sell them if the price rises enough that it becomes a viable proposition.
On the other hand, with CFDs, you don’t own anything, as you’re merely speculating on price movements. You’re entering into a contract with your broker, wagering whether the price of an asset will go up or down. If you’re right about your prediction, no matter which way it swings, you profit. If not, vice versa. On a fundamental level, that’s the entire concept of CFD trading.
Other, more nuanced differences also exist, which make them quite different, and they are:
1. Leverage and Margin
Leverage is what makes CFD trading so appealing. It is simultaneously the biggest advantage and risk. Leverage lets you control a trade much larger than the actual money you’ve put in. For example, with 10:1 leverage, you only need $1,000 to trade $10,000 worth of an asset. To put it simply, it massively increases the stakes, both for potential profits and incurred losses.
This also means there is a low barrier to entry for newcomers interested in trading. However, it’s best to educate yourself thoroughly about the concept.
2. Going Long vs. Going Short
In normal trading, generally, big money is made when prices rise. You buy low and sell high. But if prices drop, you either hold on and wait or sell at a loss. Short-selling is possible, but it’s complicated. More often than not, it requires borrowing the asset first. With CFDs, you can gain profits both when the market is rising or falling because shorting is easy.
You can profit from falling prices just as easily as rising ones by placing a sell order when you predict a stock, currency, or index will drop in price.
3. Trading Costs
Both CFD trading and normal trading have costs, but they differ.
Normal trading usually involves commissions, spreads (the difference between buy and sell prices), and sometimes overnight holding fees. If you own stocks, you might also pay broker fees.
CFD trading often has higher spreads since trades go through a broker. Some brokers charge commissions, and if you hold positions overnight, you pay a swap fee, which is the interest on the leveraged amount.
Also, be sure to learn the difference between CFD broker vs Crypto exchange.
4. Market Access and Flexibility
Another massive difference between the two is market access and the flexibility on offer. Normal trading is limited to specific markets. If you trade stocks, you need to go through a stock exchange. If you trade forex, you need a forex broker. Far from convenient.
CFDs give access to multiple markets from one account, which are stocks, forex, commodities, indices, and even cryptocurrencies. Choosing the right platform matters, but if done so, there is a lot more flexibility for traders who want to switch between different assets.
What are the Advantages of CFD Trading Over Normal Trading
It’s important to understand that no trading method is 100% perfect, but there are pros and cons to each. You must evaluate these differences to make the decision best suited for your trading goals. Let’s look at some advantages of CFD trading and why it might be preferred over traditional trading:
1. Profit When Prices Rise or Fall
Buy low, sell high is a basic principle in long-term investing. In this strategy, you buy stocks when prices are low and sell when they rise. However, this strategy relies on market growth, meaning you can only profit in a bullish market, and you must also time it just right.
This is, arguably, a limitation, as most of the profits are to be gained only when the market is rising. If the market drops, you’re stuck holding your assets and waiting, or you must sell at a loss. (It is more complicated than that, as short-selling is undeniably possible through borrowing, but this is essentially how things work.)
With CFDs, no matter which direction the market moves, as long as you predict an asset’s value correctly, you can garner profits from both bullish and bearish markets. This eliminates the often restrictive nature of traditional trading.
2. Amplify Gains with Leverage
Trading can be expensive due to the concept of ownership. You need a certain sum of money to get started, which can be low but is always higher than what CFDs require.
CFD trading, with the concept of leverage, allows you to start with a smaller deposit while still trading at a higher value. This leverage is often 10:1, 50:1, or even 100:1, depending on the broker and platform. It allows you to control a much larger position with a smaller amount of money.
3. Avoid Stamp Duty & Lower Fees
When there is no ownership, there is no stamp duty. The UK incurs stamp duty, a form of tax on stock purchases. CFDs have no concept of ownership of an actual asset, so there is no stamp duty.
Besides, it has lower trading fees. You’re typically only paying the spread and overnight fees for holding positions overnight, though these are usually much lower than traditional margin fees.
4. Hedge Without Selling Your Assets
CFDs are a great tool for hedging. Let’s use an example to understand how this works in practice.
If you own $10,000 worth of Tesla stocks but expect a short-term drop due to a major political or economic change, instead of being forced to sell your shares (incurring taxes and losing out on predicted long-term gains), you can simply short Tesla CFDs. If the stock price falls, your CFD trade profits offset the loss your stock portfolio suffered.
5. Trade 10,000+ Markets in One Account
Traditional trading requires a separate account for different assets. One for stocks, another for crypto, and yet another for forex. Hardly up to modern standards. CFD trading makes it possible to trade all these markets from a single account. It varies from one platform to another, but generally, all offer access to:
- Forex
- Stocks
- Indices
- Cryptocurrencies
- Commodities (gold, oil, silver)
This makes CFDs a one-stop shop that is convenient and time-saving.
6. No Expiry Dates = Flexible Holding Periods
Unlike futures and options, which tend to have an expiry date, CFDs can be held indefinitely. While this does mean there will be overnight financing costs, if you believe an asset will rise in the long run, you can keep your position open as long as you want.
This flexibility is especially useful for swing traders who hold positions for days or weeks without worrying about contract expirations.
CFD vs. Traditional Trading: Side-by-Side Comparison
For an easier understanding, here’s a table comparing the major aspects of CFD trading with traditional trading.
|
Factor |
CFD Trading |
Traditional Trading |
|
Leverage |
High leverage allows you to control larger trades with smaller deposits. |
Limited leverage, often lower than CFDs, with strict margin requirements. |
|
Costs |
Overnight holding fees, spread charges by brokers, and sometimes even commissions. However, no stamp duty. |
Typically lower spreads, but commission-based for stocks. Stamp duty applies in some markets. |
|
Short-Selling |
Short selling is possible, easy, and convenient, and it does not require borrowing assets. |
Short selling is complicated, often requiring stock borrowing and margin accounts |
|
Market Access |
Trade multiple markets (stocks, forex, crypto, commodities) from one platform. |
Separate accounts are required for stocks, forex, and other assets, making access less streamlined. |
Risks of CFD Trading (And How to Avoid Them)
It’s best not to look at CFD trading through rose-colored glasses and be hypnotized by its various advantages. All trading tools come with risks, and CFDs are no different.
All the benefits of CFD trading come with equally high risks that can wipe out your account if you’re not approaching it strategically. Here are three major risks to watch out for and how you can avoid them:
1. Over-Leveraging Can Wipe Out Your Account
The concept of leverage is what makes CFDs so tempting and so easy to access. However, it also has its downsides. While it does allow you to control large positions with a small deposit, you can just as easily find yourself in a position where you’re incurring losses, overexposing yourself, and liable to pay the fines.
The way to combat this is simple: use lower leverage if you’re just starting. Understand the concept deeply so you’re not tempted into a trade simply because a broker offers 50:1 leverage (it doesn’t always mean you should use it).
Moreover, it’s a good idea never to risk more than 1-2% of your capital. The exact percentage may vary, but the fundamental point is to avoid completely wiping out your account. Lastly, set stop-loss orders to limit potential losses before they snowball.
2. Market Volatility Can Cause Huge, Unexpected Losses
The CFD market can be extremely volatile, especially during major news events. Politics, social changes, central bank announcements, and economic reports, all have an impact. If you’re caught on the wrong side of a trade, losses can be rapid. However, on a positive note, volatility works both ways. Here are three tips to work around this problem:
- Check the economic calendar before initiating a trade and avoid trading before major news events.
- Use a stop-loss.
- Consider reducing position sizes when trading in uncertain or highly volatile markets.
3. Emotional Trading Leads to Poor Decisions
This suggestion is undeniably one of those “easier said than done” ones. We are human and almost at the mercy of our emotions. However, the idea is not to let emotions override logic when trading. It’s best to keep in mind what is at stake, after all.
Traders often let their emotions get the better of them, whether induced by panic after a loss or greed after a win. Concepts like revenge trading and overtrading are all too common (you see how they even have their dedicated names). These behaviors drain your account quickly.
Stick to a trading plan and tackle risks by having a clear entry and exit point. Accept losses as a part of trading rather than indulging in risky trades to cover them. Also, take a break when needed. Trading when restless, emotional, or frustrated rarely leads to positive outcomes.
How XBTFX Can Simplify CFD Trading
CFD trading requires access to a platform that offers plenty of relevant features and is transparent with its policies and business model. We heard that, and introduced XBTFX.
Having won the Crypto Broker of the Year award, we provide traders with benefits such as:
- Access to over 200+ instruments across various asset classes, including forex, cryptocurrencies, commodities, indices, and shares.
- Ability to choose between industry-leading platforms like cTrader and MetaTrader 5.
- Access to an internal social trading platform where experienced traders can generate income from their successful strategies, and beginners can choose from existing strategies provided by professionals.
- High leverage of up to a 500:1 ratio.
- Support for various account types, including corporate accounts, ECN, standard accounts, as well as Islamic accounts that comply with Sharia law.
Join over 50,000+ traders worldwide who have chosen XBTFX as their trusted broker. Create a free account and start CFD trading with us today.
Conclusion
CFD trading gives you great flexibility. However, to find success, you need to have a proper understanding of leverage, spreads, short-selling, as well as the ability to manage risks. Overleveraging, emotional trading, and ignoring external factors like economic news can lead to costly mistakes.
Eventually, it boils down to having a solid strategy, discipline, and always staying ahead of the game.
FAQs
What are the advantages of CFD trading?
The biggest advantages of CFD trading include the ability to profit from both rising and falling markets, access to leverage, which allows traders to control larger positions with lower upfront capital, exposure to thousands of markets, and the ability to hedge existing investments without selling assets.
What are the pros and cons of CFD trading?
The pros of CFD trading include flexibility, ease of short-selling, and leveraged trading. However, the cons include the risk of rapid losses due to leverage, overnight holding fees, and dependence on broker policies. Another downside is that CFDs are not ideal for long-term holding, as they require active management.
Does trading share CFDs carry greater risk than physical share trading?
Generally, yes. CFD trading is considered riskier than traditional share trading because of leverage, which magnifies both gains and losses. Besides, the low barrier to entry can lead to overleveraging, particularly among inexperienced traders. Market volatility also increases the risk.
Is CFD trading good or bad?
CFD trading is neither inherently good nor bad, but it is simply a trading instrument. While it offers opportunities to profit in both bullish and bearish markets, it also carries significant risks. If beginners do not manage risk properly, they can incur heavy losses. However, if done right, it can be incredibly fruitful.
