In this article, we will cover what CFDs are as well as the dangers and risks of trading with CFDs.
IG Index was founded in 1974 and is a spread bet and CFD (Contract For Difference) provider in the UK and other countries. It also offers share dealing and Individual Savings Accounts (ISAs). It is listed on the London Stock Exchange with the EPIC code: IGG.
IG Index also offers L2 Dealer for its clients. This is a downloadable program that can be used to trade the UK stock market with via CFDs. It also offers various other markets and asset classes.
There is also a link to open a CFD account with IG Index here.
What is a CFD? What is a Contract For Difference?
A CFD – or a Contract For Difference – is a financial derivative. CFDs allow us to take a position going long or short on various instruments but without taking ownership of the underlying asset.
With CFDs we can speculate on rising and falling prices across a range of markets, including shares, forex, indices, and commodities.
What Is CFD Trading?
CFD trading is the buying and selling of contracts for difference via the CFD provider. A CFD trade is an agreement between ourselves and the provider to exchange the difference in the price of the asset traded from the point the CFD is opened and the point when the CFD is closed.
CFDs are leveraged products and can magnify both wins and losses, and so leverage must be applied carefully.
How Does CFD Trading Work?
CFD trading works by allowing traders to take positions on various assets and speculating on both a rise in price or a fall in price. There are several concepts to understand here, such as going long and short, leverage, and margin.
What Do ‘Long’ and ‘Short’ Mean In CFD Trading?
In CFD trading, going ‘long’ means a trader is taking a position with the belief of a rising price. This is similar to buying the asset class only we do not own it with a contract for difference.
Going ‘short’ is the opposite of going long, and a trader would take a short position if they believed that prices would fall and wanted exposure in that asset.
Being able to go long and short is one of the main benefits of CFD trading, as in ISA accounts we are only able to buy shares – or go long.
For example, if you believed that the share price of Vodafone would rise in value, then opening a CFD long position of 2,000 shares would mean that when the position is closed we would exchange the difference in price of the contract from the opening to the closing of the position.
This is the same for going short and speculating on a falling price too – both profits and losses are realised when the position is closed.
What Is Leverage In CFD Trading?
Leverage means that we are able to gain exposure to a position without having to put up the capital upfront. For example, if we wished to purchase 2,000 Vodafone shares, then with a CFD contract we would only need 20% of the initial capital required to purchase this position via share dealing.
One benefit of leverage is that it means we can work our capital harder; however, many private investors and traders lose when trading leveraged products and so we must exercise caution when trading these products.
What Is ‘Trading On Margin’ With CFDs?
If we refer back to the example in the paragraph above, the 20% of the exposure for the position of 2,000 Vodafone shares is referred to as the ‘margin’.
Margin is the amount of money required to both open and maintain a leveraged position and for retail traders and investors this is 20% and above.
If an account’s equity falls too low, you may be required to top up the account with further funds or see the position closed. This is due to the negative equity protection that the European Securities and Markets Authority (ESMA) introduced in 2018.
How Do I Open a CFD Trade?
When we buy shares, the stock is quoted in two prices: one price to buy, and another price to sell.
This is the same when trading CFDs and so there is a sell price (known as the ‘bid price’), and the buy price (or the ‘ask price’).
When trading short, we would open a position at the sell price, and close the position via the buy price.
When trading long, we would do the opposite and open a positive at the buy price, and close this position with the sell price.
When trading stocks with a CFD account at IG Index, we are able to place our trades directly onto the orderbook with Direct Market Access. This means we become a market maker offering to provide liquidity to the market at a specified price and in a certain size.
How Do I know What Size Position To Open?
When buying stocks in a CFD account this is very similar to when we buy shares. If we want to get exposure to 2,000 shares of Vodafone in a CFD account, then we would buy 2,000 shares in a CFD account like we would in our share dealing accounts.
How Do I Calculate My Profit and Loss On The Trade?
In order to calculate the profit or less on a CFD trade, we have to take the size of the position (the number of contracts) and multiply this by the price of the CFD at open. We then do the exact same only we multiply the size of the position by the price of the CFD at close. The difference is our realised profit of loss.
Profit or loss =
(Number of contracts x value of contract at open) –
(Number of contracts x value of contract at close)
This would be the profit or loss on the position before any charges or fees that we paid have been subtracted. For example, CFDs on shares have overnight funding charges, and a position that has ran on for several days would have incurred fees to keep this position open.
It also doesn’t include commission or any guaranteed stop fees.
For example, if we wanted to get exposure to a stock that we believed would rise, we could buy shares in a CFD account to do this, and if we wanted to take a position short then we would sell our desired amount of stock and go short.
Frequently Asked Questions About CFDs
How Can I Get Started With CFD Trading?
CFDs can be traded with IG Index in a CFD account.
There is a free demo account provided with IG Index so that you can understand how the platform works properly before trading with real capital. The demo account is clearly signposted.
How Are CFDs Taxed?
When buying shares through a CFD account we do not pay stamp duty as we do when buying stocks in a share dealing account.
However, CFDs are not exempt from Capital Gains Tax unlike ISA accounts.
Is It Safe To Trade CFDs?
All trading involves risk. Leverage involves more risk because both the profits and losses are increased – always ensure that you are not over-exposing when trading CFDs.
Limiting risk can be done in the form of a stop loss, and IG Index offers guaranteed stop losses too. These will charge a premium if triggered, but they are the safest way to trade as losses are guaranteed to be capped at the stop level.
As with trading any asset class or market, one should never trade with more capital than they can afford to lose.
What Is The Difference Between Spread Betting and CFDs?
Spread betting and CFDs are similar in the fact that they are both leveraged products.
Some of the main features of both CFDs and spread bets include:
- The ability to go long and short
- Offer trading on margin with leverage
- No stamp duty
- The price is based on the underlying asset traded
However, there are some key differences between the two.
Unlike spread betting, CFDs differ in the following ways:
- Direct Market Access (DMA) availability on equities and forex
- CFDs are subject to Capital Gains Tax unlike spread betting
- CFDs charge an opening commission
- Losses can be offset against profits for tax planning purposes
Spread bets and CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 71% of retail investor accounts lose money when trading spread bets and CFDs with this provider. You should consider whether you understand how spread bets and CFDs work, and whether you can afford to take the high risk of losing your money
