What is CFD trading and how does it work?
CFD's or contract for differences have become extremely popular among investors. But what are CFD's exactly and how to invest in them? In this article you will read everything you need to know about this popular derivative.
Where can you trade CFD's?
Special CFD brokers are the place to be to invest in CFDs. Let’s take a quick look at two well-known and reliable CFD brokers:
Another reliable party where you can trade in CFD’s is eToro. At eToro you can use advanced analysis tools. This makes eToro very suitable for the serious trader who wants to be active in day trading. Use the button to open a free demo account with eToro:
Plus500 has been fully optimized to guarantee smooth CFD trading. To go even one step further, investing in CFDs is the core and only business they offer. The Plus500 software is extremely user-friendly, and you can start trading CFDs on all known shares, commodities, index funds and currency pairs. A nice additional feature about Plus500 is the fact they offer a free of charge and unlimited demo which allows you to try out all possibilities.
What are CFD's?
A CFD is a derivative. This means CFD's always relate to an underlying asset. This could, for example, be an Apple share. The different parties come to an agreement to exchange the price difference between the opening (purchase price) and the closing (sell price) trade price of the underlying asset. CFD trading of the Apple share has many similarities with trading an Apple share directly.
Below you will immediately see what we discuss in the manual about trading CFD's:
- CFD trading: how can you trade in CFD's?
- Leverage: how can you apply leverage?
- Margin call: what is a margin call?
- Stop loss: what is a stop loss?
- Falling prices: how can you benefit from falling prices?
- CFD costs: what are the costs of CFD trading?
- Advantages & disadvantages of CFD trading.
How can you trade CFD's?
You can trade in CFD's at an online broker. When you trade in a CFD you always have two options:
- Buying: you speculate on a price increase in the underlying asset.
- Shorting: you speculate on a decreasing price of the underlying asset.
How can you use leverage?
An important CFD feature is the possibility to make use of a so-called leverage. When you use leverage, you only have to invest a small part of the total investment. The maximum leverage ratio which can be applied by a private person is 1:30. Leveraged trading has the advantage it can be used to achieve larger profits. A clear disadvantage is the bigger risk on losses.
Tip: using a high leverage is an optional feature, it’s all up to you whether to use it or not!
But how does CFD leveraged trading work? When you open an order, you need to specify the trading amount. A leverage ratio of 1:5 is used if the balance on your account is $1.000, and you decide to buy $5.000 of CFD shares. If you apply leverage both your potential profits and your potential losses increase:
- When the CFD share increases with 10% your profit would be 50%.
- When the CFD share decreases with 10% your loss would be 50%.
Leverage allows you to do a bigger investment with a smaller amount of money. Nevertheless, it is important to remember that trading with leverage is a risky affair. When you do not have enough money on your account you can experience a margin call. With CFD trading, you can lose your entire investment.
Watch out for the margin call
Brokers do not want to lose money, and therefore they have implemented a built-in protection layer. After all, a broker doesn’t want to be accountable for your losses. Therefore, the use of a leverage goes hand in glove with a margin. When the asset price decreases with 20% all the money on your account will be lost when you apply a 1:5 leverage.
If the price would further decrease to 21%, the broker would have to invest extra money. To prevent a similar situation, brokers make use of a margin call. When your balance moves towards $0, the broker will request you to deposit money to avoid closure of the position. When you do not deposit additional funds, the broker will be forced to close your positions to prevent them from making a loss themselves.
The margin call can be a very annoying feature. It’s therefore of crucial importance to carefully consider beforehand if you can compensate the expected price fall before the actual price increase when buying a CFD. If you are not careful you risk losing your entire investment on a single trade.
Using a stop loss
A proper way to prevent a margin call, is to make use of a stop loss. Installing a stop loss is pretty easy within the CFD trading software. The stop loss indicates at which loss percentage your position will automatically close.
It’s wise to always use a stop loss. That way, you can prevent one negative position from blowing up your entire account. When you want to use a guaranteed stop loss you will have to pay an extra commission. In exceptional market situations (such as a market crash), a delayed stop loss can sometimes occur. With a normal stop loss, you would have to pay for this delay. However, with a guaranteed stop loss these costs are covered by the broker.
Besides using a stop loss when trading CFD's, you can also use orders. An order will allow you to set a value at which you will automatically open a certain position. A stop loss can ensure your loss does not increase too much. You can also set a take profit which indicates the level at which you automatically take your profit.
By combining all these features and functionalities you can automate CFD trading to a large extent. Logically, it all starts by executing an extended analysis. Nevertheless, when you know all the ins and outs and what to do at which moment, you won’t to have to sit in front of your computer 24/7 anymore. This will save you time and some blurry eyes!
Placing an order at a CFD broker.
Profit from falling prices
Another clear advantage of CFD trading is the fact you can also benefit from falling prices by going short. You can go short by pressing the short button within your CFD broker account. By going short with your CFD, you will directly profit from falling share or asset prices.
When you buy shares directly, it is rather difficult to profit from falling prices. CFD trading nevertheless makes it possible to profit from a wide range of different market fluctuations and circumstances.
What are the CFD trading costs?
CFD trading is unfortunately not free. When you trade CFD's you do not pay a fixed commission rate. This is favourable for traders that want to invest small amounts of money. You do pay a so-called spread when investing in CFD's.
The spread is the difference between the purchase and the sell price. Depending on the volume a spread on an asset can increase or decrease.
When you trade in CFD's you will also have to consider the financing charge. When you trade in CFD's, the broker lends you money to hold your position. With a 1:5 leverage ratio 80% of the money belongs to the broker. To maintain this position, the broker charges a daily financing charge.
This financing fee will only be charged when you decide to hold a position overnight. The financing fee percentages are always displayed next to each CFD. Logically, The transaction costs on a daily basis are pretty low. CFDs are nevertheless not really favourable as option for long-term investments. In the long run the financing fees quickly rises to a few percent and this will be at the expense of the profit.
When you start trading CFD's you might notice that the value of a CFD is closely related to the value of the actual stock. This means that you do not have to do complicated calculations when you start trading CFD's. Many other derivatives require quite some calculation effort to determine your profit. Determining your return on CFD's is a lot more convenient. Let’s exemplify this by using a fictitious investment on an Apple CFD:
In the first example we are buying a CFD. Let’s suppose you are buying a CFD on the Apple share. The current price is $200. Your account balance is also $200. You decide to buy 5 CFD shares by using a 1:5 leverage. The share price then increases from $200 to $220. In this case, your profit is $20 per share. You have achieved a 50% profit instead of a 10% profit.
You can also invest in a CFD to speculate on a price fall of the CFD Apple share. In the previous example the CFD Apple share price was $200. Let’s suppose you also have a $200 balance on your account. You again buy 5 shares, and you use the 1:5 leverage. The share price increases again from $200 to $220. In this particular case, you lose $20 per share. The leverage has caused a 50% loss instead of a 10% loss.
By trading in CFD's with leverage you are magnifying your profits and losses. A broker’s software will often show you in real-time how much you have gained or lost. We nevertheless do advise everyone to make this kind of calculations before opening a position. This prior calculation will help you to determine whether the trade justifies the risk.
Furthermore, it is important to remember that although it is easy to understand the underlying mechanism of CFD's, CFD investing is far from easy. You have a high probability of losing your full deposit.
- You do not pay fixed transaction costs on CFD's.
- You can use a leverage to magnify your profits (and losses!).
- You can speculate on falling prices by going short.
- By using a stop loss, you can limit your potential losses.
- All possibilities can be tested via a demo.
- You can trade in various known assets.
- CFD trading starts at only $100.
- The margin call can make you lose your entire investment.
- You pay a financing charge for long-term positions.
- Your losses can quickly accumulate.
Trading in or speculating with CFD's can be exciting. CFD's offer a lot of flexibility and possibilities. CFD's can therefore be more attractive than many other derivatives. But don’t be fooled by the simplicity at first sight. A CFD can be a negative game changer and when you take a wrong decision, you can lose your entire investment in the blink of an eye. Therefore, the first step should be to practice using a free demo. Use this button to open a free demo account and start practising trading in CFD's:
Information about trading CFDs
Start trading CFDs today
Tutorials concerning trading in CFDs
- How does trading in CFDs work?
- Trading with leverage explained
- Managing your positions (take profit, stop loss, orders...)
- Profits and losses (balance and margins)
- The cost of trading in CFDs
Try trading risk free?
Advantages and disadvantages of trading in CFDs
CFD trading is still very popular. But what are the biggest advantages and disadvantages of trading in CFDs? In this article, we answer that question and help you decide whether trading CFDs is for you. What are CFDs? Before we address the biggest benefits and disadvantages of CFDs, we will briefly address what CFDs are. … [Lees meer]
Costs of trading CFDs
When you trade in CFDs, you have to pay transaction fees. A big advantage of CFDs is the fact that your transaction costs are relative to the amount you trade with. As a result, it is also possible to achieve a positive result when you trade with a small amount. But what costs do you … [Lees meer]
How does investing in CFDs work?
CFD stands for ‘contract for difference’. Investing by means of a CFD is just that little bit different. But what is a CFD and how does investing in CFDs work? You can read all about it in this article! What exactly is a CFD? CFD stands for contract for difference which is a so-called derivative. … [Lees meer]
Leverage: trading with leverage explained
When you invest you can apply leverage. But what is leverage? Simply put, leverage makes it possible to make a larger investment with the same amount of money. This allows you to take greater advantage of price fluctuations. But how does leverage work and what are the risks of trading with leverage? What is leverage? … [Lees meer]
Opening positions when trading CFDs
If you want to invest in certain security via CFDs, you can open a position. In this article, we will explain how you can open and manage a trading position. For this tutorial, we used Plus500‘s trading platform. Once you understand how opening a position with leverage works, you are ready to start investing with an online … [Lees meer]
Profit and loss on CFDs: balance explanation
In this article we look at how the profit or loss on investments in CFDs is calculated. It is good to read the article on how the leverage works when you do not yet know exactly how it works. Leverage plays an important role when trading CFDs. Understanding your balance with an online broker At … [Lees meer]
Profit and loss on CFDs: balance explanation
In this article we look at how the profit or loss on investments in CFDs is calculated. It is good to read the article on how the leverage works when you do not yet know exactly how it works. Leverage plays an important role when trading CFDs.
Understanding your balance with an online broker
At most brokers, your balance will be made up of a few parts. Firstly, there is the available balance. The available balance is the part of your assets which is available to invest and which you can use to open new trading positions. Please note that it is important to have enough available funds to support your open positions. If this is not the case, you may incur a margin call.
The second part of your balance is the Profit and/or Loss (P&L). The Profit and/or Loss is calculated by adding up the results of the various open positions. The result of a position is determined by looking at the profits and losses of all open positions. Only when the position is closed the profit or loss is definitive. Let’s illustrate this with an example:
- 500 ING stocks with an outstanding profit of $1200
- 120 Apple shares with a loss of $450
- In this case, your Profit/Loss is $1200 minus $450 which is $750.
The last part of the balance is Equity. The Equity consists of the capital available on your account settled with the open trading positions. If the open positions are positive, the Equity will be higher than the available capital. However, if the open positions are negative, Equity will be lower than the available capital.
- You have $10,000 available and $750 profit, the Equity will be $10,750.
- You have $10,000 available and $750 loss, the Equity will be $9,250.
Initial margin & maintenance margin
With a leverage account, you have to take into the so-called margin into account. There is always an initial margin and a maintenance margin.
The initial margin is determined by the leverage effect. When leverage is one to 10, the margin required to buy or sell a CFD will be 1/10th of the value of the security.
The maintenance margin is then the percentage of the value of the security that must be present in the account to keep the position open. If the balance is insufficient, there will be a margin call after which the position is automatically closed. Read more about the exact operation of a margin call here.
How does investing in CFDs work?
CFD stands for ‘contract for difference’. Investing by means of a CFD is just that little bit different. But what is a CFD and how does investing in CFDs work? You can read all about it in this article!
What exactly is a CFD?
CFD stands for contract for difference which is a so-called derivative. When you invest in a CFD you do not trade directly in, for example, a stock. No, in CFD trading you enter into a contract with the broker to trade in a particular security. You can bet on a price increase as well as a price decrease.
How does investing in CFDs work?
You can invest in CFDs at an online broker. Click here to open an account with an online broker. CFDs track the price of an underlying security. You can use CFDs to invest in, for example, shares, commodities and currencies. To open an investment position, you must choose one of the following options:
- Buying: you obtain a positive result when the price goes up.
- Shorting: you obtain a positive result when the price falls.
The difference in price between the moment you open the position and the moment you close your position determines your result. When you buy a CFD stock for $5 and you close the position at $10 you achieve a $5 profit per stock. However, you do not own the stock itself, you only trade in the underlying asset. You can read more about how the profit and losses works with CFD trading here.
Leverage with CFDs
It is possible to use a leverage for CFDs. Leverage makes it possible to open a larger investment with a small amount of money. In short, it allows you to invest with money that you do not deposit yourself. However, the results you achieve are entirely yours. You can read more about the exact operation of the leverage here.
With a CFD, the broker therefore covers the major part of your investment position. Fortunately, this does not mean that you can lose more than your deposit. Thanks to the so-called margin call, your positions are automatically closed when there is not enough money left in your account.
But how can the broker let you invest by means of leverage? They can do this because they normally hedge the positions. This means that they take an opposite position. As a result, the broker (almost) never loses money on the position. However, they do make money by calculating a so-called spread. The spread is the transaction cost, you can read more about it here.
How CFDs work
You now understand the basics of investing in CFDs. When you are ready, you can open trading positions in stocks, commodities and index funds, among others. The difference between the buying and selling price then determines the profit or loss.
Opening positions when trading CFDs
If you want to invest in certain security via CFDs, you can open a position. In this article, we will explain how you can open and manage a trading position. For this tutorial, we used Plus500‘s trading platform. Once you understand how opening a position with leverage works, you are ready to start investing with an online broker.
Long or short: buy or sell
With CFD brokers you can go long and short. When you go long (buy) you speculate on a rise in the price of, for example, a share. When you short sell, you speculate on a fall in the price of a share.
You can use the buy and sell buttons within the Plus500 platform.
Opening position and leverage
When investing, you must decide how much you want to buy. If you want to trade in the Dow Jones with a leverage of 1 : 4 and a capital of $1000.00, you open a CFD position worth $4000 on the Dow Jones.
When you open a position, the value indicates the total value of the investment. The required margin indicates the minimum amount of money that must be present in your account to prevent a margin call. With a margin call you lose your entire trading position.
Do you want to know more about investing with leverage? In our article about trading with leverage you read everything you need to know:
Illustrative prices. Open a position at Plus500
It is always advisable to enter a take profit and stop loss. These are the values at which you close the position automatically.
Within the Plus500 platform, you do this with the close at profit and close at loss buttons.
Orders: buy at a certain price
The nice thing about trading with CFDs is that you can also use orders. You only buy or sell a security when a certain value has been reached. When you combine orders with a take profit and stop loss, you can develop an automatic investment strategy yourself where you only have to update your orders a few times a week.
For this, you can use the option only to buy when the price is at Plus500 under advanced.
Manage open positions
With an open position, you can always see the profit or loss. You can close a position manually at any time. However, always do this because it fits your strategy. It is also possible to adjust other aspects of your trade like the take profit and stop loss.
When a position is closed, you will see the result under closed positions. Your win or loss is automatically updated when trading in CFDs. You can read how this works here.
Advantages and disadvantages of trading in CFDs
CFD trading is still very popular. But what are the biggest advantages and disadvantages of trading in CFDs? In this article, we answer that question and help you decide whether trading CFDs is for you.
What are CFDs?
Before we address the biggest benefits and disadvantages of CFDs, we will briefly address what CFDs are. With CFDs, you can speculate on price increases and price falls of, for example, a share. It is possible to use a leverage that allows you to open a relatively large position with a small amount of money.
Do you want to know more about trading in CFDs? Read directly how CFD trading works.
What are the biggest benefits of CFDs?
- Leverage: You can apply leverage to your investments.
- Take advantage of price falls: you can speculate on a price drop.
- Similar to normal investing: trading CFDs is similar to normal investing.
- Relative costs: the costs of CFDs are relative and free off commissions.
- Extensive options: CFDs can be applied to a wide range of securities.
- Losses are limited: you can never lose more than you deposit.
- Demo: you can try trading in CFDs completely free with a demo.
What are the main drawbacks of CFDs?
- Leverage risks: leverage also entails additional risks
- Financing costs: financing costs make investments impossible in the long term.
- Time: You need more time to actively trade in CFDs.
- Psychological pressure: psychological pressure is higher when trading in CFDs.
- Extra spread: you pay the spread over your entire investment.
- No real shares: you can never co-own the company.
What are the advantages of CFDs?
Below we discuss the benefits of trading in CFDs.
With CFDs, you can use a so-called leverage. Leverage makes it possible to make a larger investment with a smaller amount of money. For example, if you use a multiplier of one to ten you can invest $1000 with $100. There are two ways to benefit from leverage:
- You need less money to open an investment of a certain size.
- You can benefit more intensely from a small price swing.
Do you want to know more about trading with leverage? In this article we explain how investing with leverage works:
When trading CFDs, you can speculate on rises and falls in the market. You have the option to open a short position when using CFDs. When you short sell, you get a positive result when the price drops. This makes the CFD an excellent option to take advantage of falling markets or bad news.
Do you want to know more about short selling? Read our extensive article on this topic:
It is fairly easy for the average investor to understand the prices of CFDs. The price of a CFD follows the price of the underlying security fairly accurately. When Coca-Cola shares increase, the CFD usually also increases in value.
In addition, CFDs offer the necessary additional functionalities that make trading extra attractive. When you use CFD’s you can easily place orders. With orders, you can automatically open or close investments at a certain price. You can read more about opening CFD positions in this article. In addition, there are even more benefits associated with trading in CFDs.
A major advantage of CFDs are the relative transaction costs. When you buy a share from a broker like DEGIRO, you pay a fixed commission of at least $2. At Plus500, no commissions are charged, and you only pay the spread.
With online CFD brokers, you usually only pay the spread. The spread is a fixed percentage of the value of the investment. This makes it possible to achieve a good result with your investments, even if you only deposit a small amount of money.
Do you want to know more about the exact cost of investing in CFDs? Read our article on this topic:
The extensive range of CFDs is a major advantage. With CFD brokers, you can trade in CFD’s on shares listed in different exotic regions. Besides shares, it is also possible to trade in currencies, commodities, options, ETF’s and cryptocurrencies. This extensive range of options, makes it easy for every trader to find the right product.
This makes CFD trading very flexible. With one account, you have instant access to all global markets. With your local bank, you often have to pay extra money to access international markets. CFDs are therefore very suitable for investors who are interested in more exotic investment products.
Do you want to know at which broker you benefit most from the benefits of trading in CFD’s? Have a look at our overview of the best CFD brokers:
Another advantage of trading in CFDs is that you have complete control over your losses. You can control your losses by using a stop loss. With a stop loss, your position is automatically closed at a certain loss.
Please note that for the ultimate protection you need to use a guaranteed stop loss. With a guaranteed stop loss, your position will always be closed at the value you indicate. For a guaranteed stop loss, you will pay additional transaction fees. Furthermore, it is good to know that you can never lose more money that you deposit into your investment account.
When you invest in options or futures, you will have to take the expiration date in mind. When a security expires, the position is normally automatically closed at a certain date. This is usually not the case with CFDs. This gives you more flexibility: with CFD’s you decide the duration of your investment.
Another great advantage of CFD trading is the fact that you can try the possibilities for free with a demo. Many traders lose money in the beginning because they have no idea what they are doing. By first practising with a demo you can discover whether trading CFD’s works for you.
Do you want to know where you can try CFD trading for free with a demo? Use the button below to directly compare the demo accounts of the different providers:
What are the disadvantages of CFDs?
Below we discuss the disadvantages of investing in CFDs.
Of course, there are also risks associated with leveraged trading. In practice, many consumers achieve a negative result with leveraged products. This is often because they take to many risks. It is important to remember that applying a high leverage accelerates the results. It is always important to maintain sufficient margin on your account. If you do not have sufficient funds on your account, you can lose your deposit by means of a margin call.
Another drawback of CFDs is the fact that you have to pay financing costs. After all, the broker contributes the biggest proportion of the value of the investment. Because you pay financing costs, CFDs are less suitable for long-term investments. It’s therefore better to use CFDs for investments with a time frame shorter than a year.
Another disadvantage of trading in CFDs is the fact that you also need to invest more time. When you buy shares and start a portfolio, you don’t have to pay much attention to them on a daily basis. However, when you start using CFDs, you are an active trader. It is therefore important to spend more time on your CFD trades.
It is even more important (and perhaps difficult) to keep a cool head when trading in CFDs. Because it is easy to open large investments, a higher degree of self-control is required. Many people go too far driven by greed and lose their entire deposit. Do you want to learn how you can control your emotions while trading CFDs? In this article we discuss how you can do this:
When you trade with leverage, you pay transaction fees over your entire investment. When you apply a leverage of 1:10, you also buy ten times as many shares. It is important to remember that you pay the spread over all the shares you buy.
Another drawback of CFDs is the fact that you can never trade in a real share with CFDs. You will never receive voting rights with a CFD, which means that you cannot participate in the decision-making within the company. When you really want to become the owner of a business, you have to buy the share yourself.
Do the benefits of CFDs outweigh the disadvantages?
CFDs defiantly have numerous advantages and disadvantages. For many people, the advantages outweigh the disadvantages. Thanks to the introduction of CFDs, it is possible for investors to trade with small amounts in shares and currencies.
However, it is important to remember that there are elevated risks associated with trading in CFDs. Therefore, practice enough with a free demo before making a first deposit. Are you convinced of the merits of CFD trading and do you want to try the possibilities? You can do this with a free & unlimited demo! You can also check out our full list of brokers.
Costs of trading CFDs
When you trade in CFDs, you have to pay transaction fees. A big advantage of CFDs is the fact that your transaction costs are relative to the amount you trade with. As a result, it is also possible to achieve a positive result when you trade with a small amount. But what costs do you have to pay when you start investing in CFDs?
Where can you trade cost-effectively in CFDs?
When you open many positions, it is important to choose a cheap CFD broker. After all, you pay the fees for each separate transaction. Even at low costs, your total transaction costs can rise quickly. To help you, we’ve listed some high-quality and cheap CFD brokers for you. Press the button below to directly compare the most advantageous brokers:
Do you have to pay commissions?
With most banks, you pay a fixed amount per transaction. When you buy a certain number of shares at your local bank, you always pay a minimum fixed commission regardless of your trading volume. This makes it almost impossible for consumers to invest with a few hundred bucks.
Some CFD brokers also charge a fixed commission. Fortunately, this is often not the case. For the vast majority of CFD brokers, you don’t pay commissions at all when trading in shares. This allows you to achieve good result even with little amounts of money.
When you trade in CFDs, you will directly notice that the transaction costs are always relative to the investment you make. The costs are referred to as spread, which is the difference between the purchase and selling price.
When trading in currency pairs, the spread is often clearly marked. If the spread is 2 pips, it means you pay 0.0002 per unit traded. At EUR/USD, a traded unit is 1000. So, when you trade in EUR/USD with a spread of 2 pips you pay twenty dollar cents in transaction fees (0.0002 X 1000).
This means that you will make a profit as soon as the price rises by more than 0.0002 cents! The transaction costs are very low, so you can also invest profitably with a smaller amount.
You also pay a spread on shares and commodities. At your broker you can always see what the spread is. The exact spread can sometimes be dynamic: this means that transaction costs can increase or decrease depending on the trading volume. It is therefore always advisable to check the spread before opening a position.
It’s important to remember that you pay the spread on every share you buy. With leverage, you can sometimes buy $1000 in shares with $100. You will then pay the transaction fee on the full amount of your trade. When you would open a position on 10 shares of $100 and the transaction costs per share are $0.20 then your total transaction costs will be $1. On a total investment of $100 this would amount to 1% in transaction fees.
When you trade in CFDs, you can use a leverage. Leverage makes it possible to invest on margin. The broker will then finance a large part of the investment for you. When you apply a 1:5 leverage, you only need to put in 20% of the total amount. By using leverage, you can achieve a potentially higher return with a smaller amount of money.
However, the use of a lever is not free. When you apply a lever, you pay financing interest. This interest rate is only calculated if you leave the position open for more than a day. As a day trader, you don’t have to pay any financing costs.
For short positions you sometimes receive a financing premium and for long positions the financing premium is deducted. It is wise to check the financing conditions and costs for each instrument. These costs are often calculated by charging a markup above the market interest rate. These costs are then divided by 365 (the number of days in a year).
The financing costs per day are usually low and depend entirely on the specific terms of the broker. At Plus500 you can easily find the exact financing premium per CFD. In the image, you’ll see an example of what this looks like with Plus500. Although trading in CFDs is usually mainly used for short periods (1-30 days), the low financing costs also make it possible to invest in CFDs for a longer period of time.
Due to the financing costs, CFDs are especially well-suited for short-term investments. Financing costs can significantly reduce long-term returns. It is important to remember that over the weekend you pay the financing costs for three days. On weekends, the exchange is closed, so your position automatically stays open for several days.
The premiums you pay and receive are declared under overnight premium. Illustrative prices.
You don’t have to pay financing fees with every CFD broker. At eToro, for example, you can invest without financing costs if you don’t apply leverage to your investments.
Note the cost of slippage
When you invest, you may have to deal with slippage. When you set a stop loss, you indicate that you want to sell the stock for a certain price. If the market is very volatile, the price can move a bit before the position is actually sold. As a result, the loss on your trading position may be higher than expected.
You can solve this by using a guaranteed stop loss. However, the use of a guaranteed stop loss is not free. You pay for this by, for example, paying a higher spread. Therefore, use this type of stop loss only when you expect high volatility.
Some brokers pay fees for foreign currency investments. Your investment account is always in a certain currency. When you own a euro account, you must first buy dollars before you can buy a share listed in dollars. Therefore, take a good look at how much you pay when you exchange one currency for another.
Beware of other costs
Some CFD brokers can be very sneaky. For example, they charge extra when you want to withdraw the money or if you don’t use the platform for a certain period of time. Therefore, before you open an account, research properly whether the broker charges annoying hidden fees.
How expensive is trading in CFDs in practice?
In this example, we show how expensive investing in CFDs can be. In this example, we invest in oil with a leverage of 1:10. We invest in with an amount of $1000 and the price of a barrel of oil is $40. Our total investment will be worth $10,000. For this amount, we trade in 250 oil barrels.
We pay an immediate spread over the oil barrels. In our test, the spread is 0.08 cents per barrel. We will then pay a total of $20 in direct transaction fees. This amounts to 2% on our investment of $1,000.
We will keep the position in this example open for a week. We pay a night premium – buy 0.0055% per day. In total, we pay 0.0385% in interest on the total amount of our position in one week. Our position is worth $10,000 * 0.0385% which equates to $3.85. As a percentage of our investment, the financing costs are an additional 0.385%.
Our total transaction fees are $20 plus $3.85, which equates to $23.85. On our investment of $1,000 we pay 2.385% in transaction fees. However, we are allowed to invest with an amount of $10,000 and our potential profits are ten times as high. As you can see, trading in CFDs doesn’t have to be expensive at all! We already make a profit with our investment when the oil barrels increase at least $0.40 in value.
Leverage: trading with leverage explained
When you invest you can apply leverage. But what is leverage? Simply put, leverage makes it possible to make a larger investment with the same amount of money. This allows you to take greater advantage of price fluctuations. But how does leverage work and what are the risks of trading with leverage?
What is leverage?
When you invest, you can use leverage whenever you want. Leverage is always displayed as a ratio, for example 1:30. When the leverage is 1:30, this means that you can trade with $30.000 by investing only $1,000. Leverage makes it possible to open larger trades.
Where can you trade with leverage?
Many brokers offer the possibility of applying leverage. Usually CFD’s are used for trading with leverage. You can easily apply leverage by trading with a larger amount than you deposited in your account. Do you want to know which brokers offer trading with leverage? We’ve listed the best parties for you:
The effect of leverage: some examples
When you apply leverage, your potential gains and losses increase significantly. When you buy a stock for $10 you can achieve the following results:
- With an increase of $1 you get a profit of $1.
- If the stock drops $1, you will achieve a loss of $1.
When you apply a 1:10 leverage, you get other results:
- With an increase of $1 you get a profit of $10.
- If the stock drops $1, you will achieve a loss of $10.
Later in this article, we will show how leverage works by using a more comprehensive example.
How does leverage work?
You can use leverage with an online broker. Here you see an overview of online brokers where you can trade in stocks with leverage. After opening an account you can directly use leverage. You apply leverage by investing more money than you deposited on your account. But how is the leverage handled within your investment account?
Leverage can be compared to a loan. The broker finances a large portion of the purchasing price and the difference between the opening and closing price will eventually be settled in your account balance. You are never the owner of a stock; the broker will take care of both buying and selling. When trading CFD’s, you don’t have any other responsibilities because you’re never the owner of the stock.
Example of trading with leverage
In this example, we assume that you have $1000 in your trading account. You decide to buy shares for this amount at a price of $10. The price increases during the day, and when the price hits $12 you close the position again. What would be the results of these investments with and without leverage?
Without leverage: the price has risen $2 and for $1000 you could buy 100 shares. These 100 shares have increased in value by $2. Your total profit in this case is $200 or 20%.
With leverage: you decide to apply a leverage of 1:10 to your investment. You can now buy shares for $10,000. You can open a trade on 1000 shares. These shares have increased in value by $2. Your total profit in this case is $2000 or 200%.
As you can see, in this case you would make a larger profit by using leverage. Remember, however, that the same could have happened in the opposite direction. If the price had decreased, your loss would have been larger when you would apply leverage!
Benefits of high leverage
A big advantage of leverage is that you can make larger investments with a low amount of money. You do not need to have the full value of your trade on your trading account.
A second advantage of a leverage is that it is easier to speculate on small price changes. By using leverage you can earn more money from a small price increase. This makes active trading more interesting.
Leverage financing costs
You always pay fees to use leverage. These costs are calculated in the form of financing costs. The broker finances a large part of the investment when you apply leverage. You have to pay interest on this amount. The amount of interest you have to pay on your leverage may vary by broker and by investment product.
Investing with leverage is therefore only attractive for investments in the shorter term. Do you want to make a long-term investment? Then it’s smarter to buy shares and to hold on to them for a longer period of time.
Be careful when using leverage!
Higher leverage also brings higher risks. With leverage your loses increase faster than without leverage. Remember that the leverage effect works in both ways. You should therefore use leverage responsibly.
When you just start trading it is wise to avoid using high leverage. Only when you understand how you can make money with trading it is wise to start applying leverage. When you use this powerful tool correctly you can increase your profits enormously!
When you use leverage you must have enough money available on your account. Brokers apply a maintenance margin which indicates the amount you need on your account to keep your trading positions open. When the amount in your account is no longer sufficient to keep your positions open, you will receive a margin call. This can result in losing your full investment!
When I was 16, I secretly bought my first stock. Since that ‘proud moment’ I have been managing trading.info for over 10 years. It is my goal to educate people about financial freedom. After my studies business administration and psychology, I decided to put all my time in developing this website. Since I love to travel, I work from all over the world. Click here to read more about trading.info! Don’t hesitate to leave a comment under this article.