Pros and Cons of CFD Trading

Key Learnings

• Contracts for difference allow you to speculate on financial markets without purchasing actual assets
• Many reputable brokers offer margin trading for CFDs, which can increase your profits
• You will pay tax on your CFD trading profits, unlike spread betting winnings, which are tax free
• Overtrading and poor risk management can lead to losses, beginner traders should move slowly

Pros and Cons of CFDs

There are a lot of generic pros and cons guides to CFD trading online. But what are some practical tips that will actually be useful to you as a trader?

Contracts for Difference (CFDs) are a popular financial derivative for traders looking to benefit from price movements in various financial markets without actually owning the underlying asset. This allows for a more flexible and leveraged approach to trading, potentially amplifying your profits but also your risks. As such, there are lots of trading opportunities to make a profit trading CFDs, but it’s important to be aware of the risks.

On this page, we look at both the pros and cons of CFD trading to help you make more informed trading decisions.

Advantages of CFDs

Leverage and Liquidity 

• Leverage – One of the significant advantages of CFD trading lies in the ability to use high leverage. This means that you can control larger positions with a relatively small amount of capital. While this magnifies your potential profits, it’s crucial to recognise the associated risks.
• Liquidity – CFDs will mirror the movement of the physical shares, unlike a spread bet market where the price is based on how the physical shares are trading. This means that CFDs give you access to the liquidity in the underlying market, as well as the liquidity offered by the CFD provider.

Flexibility and Diversity

• Profit in Rising and Falling Markets – Unlike traditional stock trading, CFDs allow traders to go long (buy) or go short (sell) which means you can profit from both rising and falling markets. This versatility is particularly valuable in volatile market conditions, providing opportunities for you to benefit from price fluctuations.
• Wide Range of Tradeable Markets – CFD trading offers access to a wide range of markets, including stocks, commodities, indices, and currencies. This diversity enables you to capitalise on various instruments, creating opportunities in both rising and falling markets.
• CFDs don’t expire – CFDs are not like futures, options or spread bets in that they never expire. Theoretically, you could buy or short-sell a particular CFD market and hold the position for as long as you like, provided you don’t get a margin call or are stopped out of your position.
• Good trading platforms – Most CFD brokers offer excellent online trading software to trade CFDs, either their own proprietary platforms or popular third-party platforms such as MetaTrader 4 or its upgrade, MetaTrader 5.
• Flexible Trading hours – Much like forex trading, CFDs are available to trade 24 hours a day, 5 days a week. Some CFD markets may have longer hours. You can learn more about UK forex trading hours here

Financial and Tax Efficiency

• No Stamp Duty levied – There is no stamp duty to trade CFDs, which saves 0.5% a trade (that is charged for a traditional share purchase in the UK). If you make a lot of trades, your savings will add up substantially over time.
• Tight bid-offer spreads – As most CFDs deal at the same price as if buying or selling the shares in the cash market, the bid-offer spread will be as tight as possible. This is in contrast to spread bets where the bid-offer can be wide, which therefore makes them more expensive to trade.
• Low commissions – Commissions often range in the 0.1% – 0.3% level (for both buying and selling). 0.1% is the same level the large institutions are charged, which is obviously good for you as an individual trader
• Tax is paid – Some might question whether paying tax is an advantage, but it’s always better to think in reverse. So if CFD profits are taxed (over the annual capital gains tax allowance), that also means losses are offsettable against tax, and that’s the advantage if you lose money on a CFD trade.

Hedging and Risk Management

• Hedging – CFD trading allows for effective hedging strategies. You can use CFDs to offset potential losses in your existing portfolios by taking opposite positions in a particular CFD market.
• Can Place Stop Loss Orders to Minimise Risk – Most brokers offer stops as a feature of their online software, and this is a good advantage for CFD traders. It’s important to note that stop losses are not normally allowed to be entered if you use a stockbroker to trade the physical shares (I.E. not CFDs).

Disadvantages of CFDs

High Risk Due to Leverage

• While leverage can amplify profits, it equally increases the risk of significant losses. If you’re a novice trader, you may find yourself exposed to higher risks than anticipated, emphasising the importance of cautious and informed trading. However, with proper risk control and always using a stop loss, the leverage problem can easily be controlled, and losses can be kept to manageable amounts.

Volatility

• The inherent nature of CFDs makes them susceptible to market volatility. Sudden price movements can trigger unexpected losses, emphasising the need for you to have robust risk management strategies.

Overtrading Risks

The accessibility and flexibility of CFD trading may lead you to overtrade. Overtrading can result in poor decision-making and increased exposure to market risks. Establishing disciplined trading practices is essential to mitigate this risk.

Costs and Fees

CFD trading involves various costs, including spreads, overnight financing fees, and, in some cases, commission. You must carefully consider these costs to ensure they align with your trading strategy and financial goals.

• Not suitable for long-term – CFDs may not be a suitable long-term investment due to financing costs. After holding a long CFD position for more than about 5-6 weeks, the financing costs start to get expensive. In some respects, it may be cheaper to buy and hold the shares outright rather than trade CFDs.
• Overnight financing costs – fees are charged for holding a CFD position overnight, which can add up over time.
• Inactivity fees – some CFD brokers charge inactivity fees, which incur if you haven’t traded after a certain period of time.

Tax is Levied

• Tax is both an advantage and a disadvantage. If you’re profitable, it’s a disadvantage, and depending on how profitable, spread betting, with its tax-free advantage, might be better for tax purposes.

Additional CFD Trading Factors To Consider

Once you understand the pros and cons of CFD trading, there are a number of other factors to consider before you start your CFD trading journey. These include risk management, regulatory considerations, choosing a CFD trading platform and CFD trading tips for beginners (and indeed, all levels of trader).

Risk Management in CFD Trading

Risk management is an important aspect for any trader to consider, no matter what stage you are at, from beginner to professional. Implementing a good risk management strategy helps limit your potential losses and ensures you are in control of your CFD trading at all times. There are many risk management strategies and methods you can utilise including:

Setting Stop-Loss Orders

Implementing stop-loss orders is a fundamental risk management strategy in CFD trading. A stop-loss is an order that helps you limit potential losses by closing positions at predefined levels. Some brokers even order guaranteed stop-loss orders (GLSOs), which, for a premium charge, work in the exact same way as a regular stop-loss, except for the fact that they guarantee to close you out of a trade at the price you specify, regardless of market volatility or gapping.

Diversification Strategies

Diversifying CFD portfolios across different asset classes can help spread your risk when trading. A well-balanced portfolio reduces the impact of a poor-performing asset on your overall trading account. Given certain markets have an inverse correlation to others, such as bonds and shares, diversifying your trading portfolio can act as a hedging strategy too.

Regular Market Analysis

Continuous market analysis is crucial for identifying potential risks and opportunities. Staying informed about economic indicators, geopolitical events, and market trends enhances your ability to make informed decisions. While some are better than others, most brokers offer useful educational resources and market research to analyse the markets with and stay as informed as possible.

Regulatory Considerations

When choosing a reputable CFD broker, it should be regulated by the governing body of the country you’re trading from. This is not just for legal reasons but to ensure the broker itself is trustworthy. Here are some other regulatory considerations you should make before choosing a reputable broker:

Importance of Choosing a Regulated Broker

Selecting a reputable and regulated CFD broker is crucial for ensuring a secure trading environment. Regulatory oversight helps protect traders from fraudulent activities and ensures fair market practices. The best way to check if a broker is regulated and who they’re regulated by is by checking their website. All brokers should be transparent about this information and if they are not, that’s a red flag that they may be unregulated and potentially untrustworthy.

Understanding Local Regulations

It’s important to be aware of and adhere to local regulations governing CFD trading. This includes tax implications and compliance with financial regulations specific to their jurisdiction. In the UK, the main regulator is the Financial Conduct Authority (FCA), which is a top-tier regulator. Any broker regulated by the FCA can legally offer trading services to UK traders. Some top FCA-regulated brokers we can recommend include Pepperstone, Eightcap and CMC Markets. You can find out more information on the best FCA-regulated brokers in the UK here.

CFD Trading Tips for Beginners

Once you understand the pros and cons as well as the key considerations to make regarding CFD trading, you are ready to start your CFD trading journey. Here are some step-by-step tips to help you get started.

1. Importance of Education – For beginners, acquiring a solid understanding of CFD trading is paramount. Education can help you navigate the complexities of the financial markets and make informed decisions. As mentioned earlier, most brokers offer educational resources and market research for you to learn about the financial markets.
2. Choose a reputable broker – Choosing an appropriate broker can be a tricky process, given there are so many brokers to choose from. It is also a personal process given every trader has different needs and preferences. The best way to go about choosing a reputable broker is to assess what is important to you and research brokers that offer that. Some key considerations to consider include trading costs, range of markets and trading platforms.
3.  Start with a Demo Account – Before diving into live trading, as a beginner, you should consider practicing with a demo account. This allows you to familiarise yourself with the trading platform and test strategies without risking real capital.
4. Take Small Steps Initially – Managing risk is crucial for beginners. Starting with small positions and gradually increasing exposure as confidence and experience grow can contribute to a sustainable and successful trading journey.
5. Come up with a trading plan -A trading plan is vital for all levels of trader. All good trading plans involve an assessment of what kind of trader you are, a risk management plan and a viable trading strategy for the short, medium to long-term.
6. Open a live account -Once you’ve followed steps 1 to 5, you’re ready to open a live account with a reputable, FCA-approved broker!

Choosing a CFD Trading Platform

Choosing the right trading platform is essential for a positive CFD trading experience. Like choosing an appropriate broker, there are many factors to consider when choosing the right platform for you. Again, it always comes down to personal preference but some key factors include:

Third-party or Proprietary trading platforms

Some brokers offer popular third-party platforms such as MetaTrader 4 or cTrader while others offer their own, proprietary platforms (and some offer both). Each platform has its own advantages and disadvantages but platforms like MetaTrader 4 have proven to be reliable over a long period of time. The benefit of a proprietary platform is that, given it has been developed in-house by the broker itself, it will often mean a smoother trading experience given all features are integrated in the one platform.

Trading Platform Features

Evaluating a trading platform’s features, including its user interface, reliability and ability to easily switch between multiple devices all add up to the overall usability and trading experience of the platform.

Advanced Trading Tools

Depending on what type of trader you are, you might appreciate additional trading tools to give you a trading edge. These come in the form of charting, algorithmic and social trading tools. Some traders might enjoy a more basic platform experience while others might appreciate more advanced trading tools for technical analysis of the markets.

User Reviews

Exploring user reviews provides insights into the real-world experiences of other traders. Positive reviews may indicate a reliable platform, while negative feedback can highlight potential issues. Trustpilot reviews are a good place to start, which are usually an accurate depiction of a reliable CFD platform.

CFD Trading vs Spread Betting

As a UK trader, you have the option of CFD trading or spread betting, which is another form of financial market trading. Spread betting is a unique form of speculation where traders bet on the price movements of financial instruments. Unlike CFDs, spread betting is tax-free in many jurisdictions, making it an attractive option for tax-conscious traders. Spread betting offers flexibility in market accessibility, allowing you to speculate on a wide range of assets without owning the underlying assets. However, it comes with its own set of risks and considerations.

Each instrument comes with its own set of advantages and drawbacks. CFD trading offers the potential for higher returns and diverse market access but involves higher risk due to leverage. Spread betting provides tax advantages and flexibility but may lack the same level of market access and liquidity as CFD trading. You should carefully weigh these pros and cons based on your own preferences and risk tolerance.

Calculating Spread Betting Costs and Risk

Given spread betting comes with its own costs and risks, it’s important to be able to calculate those costs so you can go into a spread bet fully informed of the potential outcome. Our calculator below allows you to plug in a potential spread bet trade to forecast your potential profit or loss, and the margin required to make that trade.

Learn more about the difference between spread betting and trading CFDs here.

Conclusion

In conclusion, CFD trading offers a dynamic and versatile approach to financial markets. Understanding the pros and cons, implementing effective risk management, and staying informed are key elements for success in CFD trading. Whether you’re a seasoned trader or just starting, navigating the complexities of CFD trading with a strategic mindset is essential for long-term profitability.

Key Takeaways

• Contracts for difference (CFDs) enable speculation in financial markets without the need to buy real assets.
• Numerous respected brokers provide margin trading options for CFDs, which can enhance potential gains.
• CFD trading profits are subject to taxation, unlike tax-free spread betting winnings.
• Excessive trading and inadequate risk management may result in losses; novice traders should proceed cautiously.

FAQs

Can you lose money on CFD trading?

Yes. Like all trading on the financial markets, CFD trading involves risks that can lose you money. This is due to the volatility and unpredictability of the price movement of financial markets. As such, the best way to prepare yourself is to study the markets and develop an informed CFD trading strategy. Preparing yourself with risk management strategies such as using stop losses will also help limit your losses. If you know how much you’re prepared to lose and have a solid trading plan in place, you will never let your CFD trading get out of hand.

Is CFD trading good for beginners?

Yes, CFD trading is suitable for beginners provided you understand the basics of CFD trading and know the risks. With proper education and risk management, you can become a successful CFD trader, even as a beginner. Starting with a demo account to practice trading before opening a live account is always advisable.

What is the best way to trade CFDs

There are many ways to trade CFDs and many financial markets you can trade as CFDs, including forex, stocks, indices, bonds and commodities. Whether you trade a share CFD, index CFD or a more complex financial instrument like an ETF CFD, the best way to trade is entirely down to your personal preference. Some popular trading methods include scalping (or day trading), algorithmic trading or social/copy trading.