What is CFD trading? Everything beginners and experienced traders need to know

The financial markets are constantly evolving, and in addition to traditional stock investments, various trading methods are emerging. Among them, CFD trading has gained significant popularity among investors in recent years. The CFD trading method is attracting attention due to its unique feature of allowing profit from price fluctuations without owning the underlying asset directly.

However, many investors tend to overlook the hidden risks by only focusing on the attractiveness of CFDs. This guide will explain in detail, from the basic principles of CFDs to actual trading methods and essential risk factors, providing a balanced perspective.

Risks of CFDs: What You Need to Know First

Before starting CFD trading, let’s examine the risks that investors must recognize.

Leverage: A Double-Edged Sword

The most prominent feature and risk factor of CFDs is leverage. For example, using 10x leverage with 1 million won of capital allows trading of 10 million won worth of assets. This greatly increases profit potential but also amplifies the risk of loss proportionally.

In a 10x leverage trade, a mere 10% decline in asset price can wipe out the entire invested capital. This is especially risky during periods of high market volatility.

Margin Calls and Forced Liquidation

In CFD trading, there is a minimum amount of funds(maintenance margin) that must be maintained in the account. If the market moves against expectations and the account balance falls below this level, the broker issues a margin call, and if additional funds are not deposited, the position is forcibly liquidated.

According to a 2016 investigation by the UK Financial Conduct Authority(FCA), about 82% of CFD investors experienced losses, most of which were due to poor leverage management.

High Trading Costs

CFD trading incurs various costs such as spreads(the difference between buy and sell prices), overnight fees, and management fees. The more frequently you trade, the more these costs accumulate, significantly eating into profits. Especially for long-term positions, overnight fees can become a substantial burden.

Increasing Regulatory Scrutiny

The International Organization of Securities Commissions(IOSCO) has recommended strengthening regulations due to concerns over investor protection related to high leverage in CFDs. Some countries are restricting or banning retail CFD trading altogether.

Basic Principles of CFDs: How Contract for Difference Works

CFD stands for ‘Contracts for Difference,’ which in Korea is called 차액결제거래. It is a trading method that settles profits and losses based on the price difference of an asset.

Fundamental Difference from Traditional Investment

In regular stock investing, you purchase and own actual shares. In contrast, CFDs do not involve owning the underlying asset; instead, you trade only on price movements. The difference in price between the contract opening and closing is settled.

For example, suppose a stock’s current price is 10,000 won. A CFD trader enters into a buy contract at this price without owning the stock. If the price rises to 12,000 won after some weeks, they earn a profit of 2,000 won. All this is possible without ever holding the actual shares.

Understanding the CFD Trading Structure

When a trader enters into a CFD contract, the broker acts as the counterparty(CFD issuer) to the market. The trader’s profit is the issuer’s loss, and vice versa.

In this process, the broker manages the margin from the trader and earns revenue through trading fees and spreads.

Position Selection: Going Both Long and Short

A major advantage of CFD trading is the opportunity to profit whether the market rises or falls.

Long Position(Buy): Entering a position expecting the asset’s price to rise. Profit is made if the price increases.

Short Position(Sell): Entering a position expecting the asset’s price to fall. Profit is made if the price decreases.

This bidirectional trading structure offers traders more opportunities.

Why Are Many People Interested in CFDs?

After understanding the risks, let’s explore why CFDs are so popular and attractive.

Efficient Capital Utilization

To buy stocks worth 1 million won in traditional investing, you need 1 million won. With CFDs, you can start a trade of the same size with just 10,000 won capital using 10x leverage. This provides access to larger markets with limited capital.

Access to a Wide Range of Assets

CFDs allow investment in stocks, foreign exchange(Forex), commodities(gold, silver, oil), cryptocurrencies, global indices, and more. This enables portfolio diversification and risk spreading.

It also offers flexibility to find opportunities in different markets when one market is weak.

Overcoming Time Constraints

While traditional stock markets have fixed trading hours, CFD markets are open nearly 24 hours a day, excluding weekends. Especially, the forex market operates sequentially across Asia, Europe, and the US, providing various trading opportunities depending on the time zone.

Even busy professionals can trade the US market after work or catch Asian market movements in the early morning.

Bidirectional Profit Potential

Being able to take both long and short positions means you can profit in both rising and falling markets. This is a significant advantage over traditional investments that only profit from price increases.

Tax Efficiency

In some regions, CFD trading has lower tax burdens compared to regular stock trading. While major shareholders pay 22% tax on domestic stock transactions, CFDs incur only an 11% capital gains tax on derivatives. Additionally, in certain countries, CFDs are not subject to stamp duty, further reducing trading costs.

How to Trade CFDs: Step-by-Step Practical Guide

Now, let’s explain how to start CFD trading practically, step by step.

Step 1: Choose a Trustworthy Broker

The success of CFD trading begins with selecting a reliable counterparty. Consider these factors:

Regulation and Trustworthiness: Ensure the broker is officially authorized by the financial regulatory authority of the respective country. This is crucial for investor protection and dispute resolution.

Cost Structure: Understand the costs involved, such as spreads, commissions, overnight fees, etc. Choosing a broker with lower costs can make a big difference over time.

User Interface: Confirm that the trading platform is intuitive and easy to use. Especially, check if risk management tools(stop-loss, take-profit) are easily accessible.

Technical Support: Ensure prompt customer support in case of issues during trading. 24-hour Korean language support is a plus.

Step 2: Open an Account and Verify Identity

Open an account with the selected broker. This process involves identity verification, residence confirmation, and declaration of trading experience. These are regulatory requirements and also protect investors.

Since CFDs are high-risk products, some brokers may impose leverage limits for beginner investors.

Step 3: Deposit Funds Carefully

Once the account is open, deposit trading funds. Follow these important principles:

Invest only what you can afford to lose. For beginners, allocating only 5-10% of total assets to CFD trading is wise, due to the high risk of principal loss from leverage.

After depositing, plan your portfolio carefully. Diversify across multiple assets rather than concentrating on a single one to reduce risk.

Step 4: Analyze the Market and Develop a Trading Plan

Before trading, analyze the market and set a trading plan. Emotional trading leads to losses.

Technical Analysis: Use chart patterns, moving averages, RSI(Relative Strength Index), and other indicators to predict market direction. For example, RSI above 70 indicates overbought conditions, signaling a potential sell.

Fundamental Analysis: Monitor economic news, central bank rate decisions, corporate earnings reports, and macroeconomic indicators. Rate hikes often lead to currency strengthening in forex markets.

Risk Management Plan: Predefine loss limits(stop-loss) and profit targets(take-profit) before each trade. These orders help prevent emotional decisions and limit risks.

Step 5: Execute Trades and Monitor Continuously

Once prepared, execute your first trade. Keep these points in mind:

Start Small: Use small amounts initially to familiarize yourself with the platform and observe real market movements.

Set Position Sizes Carefully: Determine trade size considering your account balance and leverage settings. Generally, ensure that a single loss does not exceed 2% of your account assets.

Monitor the Market: Keep an eye on market changes during the position holding period and adjust strategies as needed. Be especially cautious around major economic data releases, which can cause volatility.

Essential Concepts to Understand When Trading CFDs

Long and Short Positions

As mentioned earlier, CFDs allow you to profit from both rising and falling markets. You can take a long position(buy) when expecting an increase, and a short position(sell) when expecting a decrease, flexibly utilizing market directions.

Comparison of Stocks, Futures, and CFDs

Stocks: Traded on exchanges, actual assets are owned. Trading hours are fixed, and leverage is limited.

Futures: Traded on exchanges, with specific expiration dates. Leverage is possible but positions are automatically closed at expiry.

CFDs: Over-the-counter trading, no ownership of assets. No expiration date and high leverage are available.

Principles for Successful CFD Trading

No matter how good the opportunity, reckless trading leads to failure. Always remember these principles:

1. Prioritize Learning and Experience. CFDs are complex financial products. Gain experience through thorough education and demo trading before investing real money.

2. Trade with a Plan. For each trade, predefine entry price, stop-loss level, and profit target, and follow your plan strictly.

3. Eliminate Emotions. Avoid revenge trading after losses or overleveraging due to euphoria from gains. Maintain a calm and rational mindset.

4. Limit Position Sizes. Always be aware of leverage risks and avoid overexposure.

5. Keep Learning. Markets constantly change. Continuously update your knowledge with new information, economic indicators, and trading techniques.

In Conclusion

CFD trading methods are modern investment tools that enable efficient access to various assets. However, due to high leverage and complex structures, starting without proper understanding can be risky.

As emphasized in this guide, the success of CFD trading depends on understanding fundamental concepts, thorough risk management, and ongoing self-education.

Beginners should always start with small amounts to learn the market, gain experience, and gradually increase their scale. Consulting with financial professionals for personalized strategies is also recommended.

When approached correctly, CFDs can be a means of diversification and profit generation in your portfolio. Just remember to always exercise caution and self-control.