The basics of CFD trading - how to take your first steps

CFDs (contracts for difference) are complex and highly risky instruments, so they are generally not recommended for those who have never traded before. The high risk of CFDs mainly stems from the often excessive use of leverage (more on this later), which can increase potential gains but also magnify any losses.

For more information, read our guide about the risks you may face as a novice CFD trader. If you want to brush up your knowledge about what CFDs are and how they work, head over to our general overview of CFD trading.

If you do insist on starting your trading career by trading CFDs, it's a good idea to first open a demo account (also known as a paper trading account) at an online broker. Here, you can use virtual money to open mock positions at actual market prices, and see what would happen if you made the same trades in reality. I suggest trading with the same amount of virtual money as you would in real life - a good way to feel out your risk tolerance in case of a loss-making position.

A demo account is also a great way to familiarize yourself with the features and functions of your broker's trading platform. Speaking of which…

There are literally thousands of CFD brokers out there, with huge differences in the cost and quality of their services; so picking the right broker is crucial.

The most important factors include regulation, product selection and trading fees:

• Many CFD brokers enjoy regulation by reputable financial authorities, but many are downright scams.
• Some CFD brokers offer only a few hundred products to trade; others have tens of thousands.
• Differences in trading fees for the same CFD asset can easily be tenfold between two otherwise similar brokers.

If you want to do your own research, check out our guide on how to choose a CFD broker. But if that sounds like too much trouble, I have good news: our analyst team, including myself, have live-tested dozens of leading CFD brokers, and scored them along more than 500 data points to compile a list of the world's best CFD brokers.

Already have broker recommendations from colleagues, neighbors or friends' friends? Check if they really match your needs and compare them with other brokers using our broker comparison tool. If they're not on our list of reviewed brokers, tap into our scam broker database to at least see if they are safe and legit.

So here's the most exciting part: what does CFD trading actually look like? To demonstrate the most important steps of CFD trading, we used the demo accounts of popular CFD trading platforms - which is how you, too, should start your CFD trading journey if you have no prior experience.

Leverage

Perhaps the most defining feature of CFD trading is leverage - that is, being able to open a trading position that is actually several times larger than the funds you deposited. For example, if you have $1,000 in your account and use 10:1 leverage, you can open a trading position worth as much as $10,000. This means that your exposure to any gains or losses in the underlying asset will also multiply by 10 - which is what makes CFD trading so risky if prices move against you.

To read more about how leverage works, check out our overview of leveraged trading.

Leverage is often preset and can't be changed, but many brokers allow you to pick your preferred leverage. In the example below, we went with 20:1 leverage to buy $20,000 worth of the NASDAQ index CFD (which mirrors the performance of top US tech stocks), using our $1,000 initial investment. However, we could have picked 5:1 or even 2:1 leverage.

If you're new to CFD trading or have a low tolerance for risk, you should consider choosing lower leverage - this can limit your potential gains, but also moderate your losses if the price moves down.

If the preset leverage levels at your broker are too high and you aren't allowed to change them, you should be very careful with the size of the trades you place. Although you can reap a decent profit if the price moves up, you might face a devastating loss if the price goes down. In our example below, the preset leverage is 500:1, and it cannot be changed.

Spread costs

Another important thing to pay attention to is the spread between the 'buy' and 'sell' prices of a CFD asset. At most brokers, this spread is what you actually pay for a trade and therefore what your broker makes a living from.

If, for example, the 'buy' price of an asset is $1,000 and the 'sell' price is $999, buying a $1,000 position will give you a position worth only $999 - because that's the price at which you could immediately sell it if you wanted to. So don't be surprised if a position you just opened immediately shows a 'loss' even if the market price hasn't moved an inch.

Of course, the leverage you used for trading will influence this instant loss. For example, in our NASDAQ CFD trade, we were shown an immediate $4.35 loss, or 0.4% of our initial investment - the combination of a tiny spread multiplied by our 20:1 leverage.

To give you an even better illustration, here are two EURUSD positions shortly after opening. The first one was opened using 2:1 leverage, and the second one using 30:1 leverage, both with an initial investment of $2,000. For the first trade, the immediate 'spread cost' is nearly invisible; but for the 30:1 trade, you are immediately faced with an almost $8 cost.

To learn more about CFD trading costs, consult our guide to CFD fees.

Limiting CFD trading losses

So what happens if the price of a CFD nosedives, and this percentage loss is multiplied by your leverage? In theory, you could lose many times your initial investment. In practice, though, there are several ways to mitigate such losses.

Stop-loss orders

Perhaps the easiest way to prepare for such a scenario is to set up a stop-loss order. You can do this by setting a price at a specific distance below the current market price at which your broker will automatically close your position; so you won't have to worry about prices collapsing while you're away from your computer or mobile trading app. You can set a stop-loss price when you open your trading position.

It is also possible to initiate a take-profit order - this can help you automatically lock in profits at what you think is a reasonable level.

Margin calls

If you do not set up a stop-loss order, or if the market price skips right past your stop-loss price, your broker may issue a margin call in the case of significant losses. A margin call basically instructs you to deposit additional money to prop up your trading position.

If you fail to comply with a margin call, or if prices fall too fast, your broker may simply close some or all of your positions - often without advance warning in the case of extreme price volatility.

Overnight fees

CFDs are typically designed for short-term trading - so much so that brokers will actually charge you extra if you hold your positions overnight. This is because, technically, trading with leverage means borrowing money from your broker, which in turn involves paying interest.

Depending on the current interest-rate environment and your broker's pricing policies, overnight fees can be quite hefty and add up to a significant part of your trading costs. Remember our $1,000 NASDAQ CFD trade with 20:1 leverage? Holding this position for a week would cost us about $41.

A great advantage of CFDs is that you can trade many underlying markets in one place, from stocks and bonds to commodities and forex.

Whatever CFD you choose to trade, make sure you understand the underlying product - such as the operations of a company behind a stock CFD, or the macroeconomic and monetary policy forces that influence the movement of a currency pair.

To discover what assets you can trade as CFDs, as well as the pros and cons of trading CFDs as opposed to the underlying product, check our comprehensive list of asset types you can trade as CFDs.