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.

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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.