For the purpose of this discussion we will not assume any previous knowledge of CFD trading, so let’s start at the beginning. CFD stands for Contract For Difference. These trading instruments allow traders to speculate on price movements in markets such as currencies, commodities, shares, indices, and treasuries.

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You’re not buying the actual instrument

Note that you’re not actually buying and selling those instruments. CFDs are what is known as ‘derivatives’, i.e. their prices are just directly linked to the prices of those assets. If you e.g. buy oil CFDs for $100 000’s, and the oil price goes up by 5 percent, you will make $5 000 profit. This is known among traders as ‘taking a long position’ or ‘going long’.

You can make or lose money whether the price goes up or down

If you buy Microsoft stocks for $100 000 and prices drop by 5 percent, you lose $5 000. With CFDs, however, you can make money whether the price goes up or down, provided you get the direction right to begin with.

If you, therefore, expect Microsoft’s stock price to drop by 5 percent, you can ‘go short’ on Microsoft shares, and if the price does in fact drop, you will still make a $5 000 profit. If it should go up by 5 percent, however, you are in trouble. Read the sections on Margin and Leverage, and Stop Losses below.

Leverage - allowing you to win (and lose) big

The concept of leverage means that you can speculate on much bigger amounts than the amount you have available in cash. If a CFD broker allows you a leverage of 50:1, you can trade on financial assets worth $50 000 for every $1 000 you have in your trading account.

If you use that $1 000 to buy $50 000’s worth of CFDs linked to the oil price and that price goes up by 10 percent, you will make a profit of $5 000, or five times your original investment.

Stop losses to protect you when things go wrong

If all of that sounds too good to be true, it’s because it could be. Leverage is a double-edged sword. In the above example, you can indeed make $5 000 if you are right, but you can lose your whole trading account of $1 000 (and much more - see the section on maintenance margin below) if you are wrong and the oil price drops by 10 percent.

That is where a stop loss comes in. Nearly all CFD trading platforms will allow you to set up a price where you get out of the deal if things go against you. Let’s say you under no circumstances want to risk more than $500 of your initial $1 000 account, then just set a stop loss that will close the trade when that happens.

Margin

When you trade in CFDs, there are two kinds of margin: the deposit margin and the maintenance margin. These refer to the amount you must have in your account to do a specific trade. For the $50 000 oil CFD trade example above, the deposit margin is $1 000.

If things start to go south the broker can also ask you to deposit more money into your account to protect himself in case your losses exceed the original $1 000. This is called the ‘maintenance margin’.

Let’s say the oil price drops by 2 %, In that case, you would lose the $1 000 you initially deposited. Before that happens, the broker will most likely request that you deposit more funds.