Fundamentals of CFD Stock Trading Explained (With Examples)

CFDs, also known as contracts for difference, are a type of financial derivative that allows you to speculate on the price movement of underlying instruments without owning them. These contracts are between two parties (the buyer and the seller), requiring the buyer to pay the price difference to the seller.

Since you don't have to own the stock on paper to trade it, you can often get a lower cost with CFDs, allowing you to get a potential profit from the price movement directly. You also won't have to file any documents with a broker to buy stock shares, as you'll always be one click away from opening a position.

With the basics of CFDs out of the way, let's dive deeper into them.

Key Features of Trading Stock CFDs

Although CFDs might sound simple, it's essential to understand all of their features before trading them.

Long & Short Positions

When you trade stock CFDs, you can either take a long or short position. A long position means that you expect the price to increase so that you can buy low and sell high. On the other hand, a short position is when you believe the price will fall, allowing you to sell high and buy low.

Without CFDs, opening short positions is quite tricky. However, with CFDs, you can trade short without any borrowing costs as you're only speculating on the price.

Leverage

Essentially, leverage is a tool that allows you to control more money than you have in your account. For instance, if a brokerage offers 1:10 leverage for trading Apple stock (AAPL), it means that for every $1 you have in your account, you can trade with $10 worth of AAPL shares.

Leverage can be incredibly helpful as it allows you to make bigger profits—but it also comes with greater risks, as your losses can also amplify. For example, if the price moves against you by 1%, you'll lose 10% of your investment with 1:10 leverage.

Margin

Whenever you trade with leverage, you have to maintain a certain amount of money in your account, known as margin. The margin is the percentage of the position size that you need to have in your account to open the trade.

For example, if a brokerage offers a 40% margin for trading AAPL stock, and you want to control $100 worth of shares, you'll need to have your account balance higher than $40.

Hedging

Hedging is a technique that allows you to offset your risks by taking an opposite position in the market. For instance, let's say you're long on AAPL stock and are afraid of a potential price drop. In this case, you can open a short position on AAPL CFDs to hedge your risks.

Remember, though, that hedging will also offset your potential profits. So, you should only hedge your trades when you're confident that the market is about to move against your position.

» Are there trading terms you don't understand? Check out our helpful glossary for a quick explanation.

How Does CFD Stock Trading Work?

Before you become a good CFD stock trader, it's essential to understand the four main areas of CFD trading.

Spread & Commission

The spread is the difference in the price of the stock when you initially buy it and the amount you can sell it for. For example, if you bought GOOGL for $100 and the current sell price is $101, the spread would be 1%.

The size of the spread varies depending on the brokerage you're using and the stock you're trading. Different brokerages have different spreads for stock CFDs, so it's important to go with a brokerage with minimal spreads.

Deal Size

The deal size is the ratio between the contract for difference and the stock you'll be trading. In the vast majority of cases, the deal size is at a 1:1 ratio, meaning that for every CFD share you open, you trade with one stock share of the company.

So, when buying $500 worth of a stock trading at $100, you'll own five contracts (CFDs), each representing one share of the stock you'll be trading.

Duration

When trading CFDs, traders can hold the position for an unlimited amount of time, which isn't the case with other derivative assets like futures.

The duration of a trade can be either short-term or long-term. Short-term trades are those that last for no more than a few days, while long-term trades are those that can go on for weeks or even months.

Still, it's important to note that CFDs usually have an overnight fee, a fixed amount of money that will be deducted from your account every day you keep the position open.

» Ready to begin? Learn more about opening an account with Fortrade.

Calculating Profit & Loss

The last thing you need to know about CFD stock trading is how to calculate your potential profits and losses. To do that, you'll need to use the following formula:

Profit (loss) = (sell price - buy price) x deal size x number of contracts

For example, let's say you bought 5 GOOGL CFDs at $100 each, and the current sell price is $101. Your profit would then be:

($101 - $100) x 5 x 1 = $5

As you can see, the potential profit from this trade is quite low. However, if you were to trade with 1:10 leverage, your profit would be 10 times bigger. 

» Need more info? Take a look at this free eBook on CFDs and stocks.

Get Started Today

CFD trading is one of the ways to make a potential profit without having to go through the paperwork of physically owning the stocks. And, with the right brokerage, you'll enjoy additional advantages like a wide variety of instruments, no restrictions on opening short positions, and leverage.

Just make sure that you fully understand how it works before you start trading. This way, you'll be able to minimize your risks and optimize your potential profits.