CFD spreads are the difference between buy and sell prices and your cost for entering a trade. They add up quickly for frequent traders. More liquid assets have tighter spreads, while less-traded instruments usually have wider ones. Spreads also widen during off-peak hours when liquidity drops. To minimize costs: trade highly liquid assets during active market hours, and factor spread costs into your risk management calculations. You can't eliminate spreads, but understanding them is essential for profitable trading.
If you’ve been trading CFDs for a while, you know that costs eat into your profits. You’ll also know that what may seem quite insignificant can add up quickly.
If you’re new to CFD trading, you need to know what CFD spreads are, how they impact your profit, and most importantly, how to reduce their impact (if possible).
What Are CFD Spreads?
Let’s start at the beginning. What exactly are spreads?
When you look at any CFD on a trading platform, you’ll see two prices listed. The one is the price you’ll pay to buy, and the other is the price you'll pay to sell. The difference between these two prices is the spread. This difference in prices represents the cost of entering a trade with your broker.
A good example to understand it better is currency exchange. If you’re at an airport and want to exchange one currency for another, they will offer to buy your dollars at one rate and sell foreign currency at another. They make money from that difference. CFD brokers operate in a similar way. They quote a buy price higher than the sell price, and that’s their profit for facilitating your trade.
The moment you open a CFD position, you’re impacted by the spread. If you were to buy a position and immediately want to turn around and sell it, you’d have to do so at the sell price. So, you’re actually immediately “in the red”.
It's worth noting that different financial instruments have different spreads. Generally, the more liquid an asset is, the tighter the spreads. However, if you are trading something not many people trade – like exotic currency pairs, the spread will be a lot wider.
How do CFD Trading Spreads Impact Overall Costs?
CFD spreads are not a once-off cost that traders must factor in. They are an ongoing cost that needs to be accounted for every time you open a trade. However, they’re not the only expense you need to consider. A CFD broker may charge a commission each time you trade (on top of the spread). Also, consider that if you hold positions overnight, you may be liable for overnight financing charges (also known as swap fees).
Retail traders are most impacted when they trade frequently – meaning those who open and close positions often, such as day traders or scalpers. The cumulative effect of spreads can add up quicker than you realize.
Let’s use a real example:
Let’s say you’re taking 50 trades per month on share CFDs with an average spread cost of 5 cents. If your average position is 1,000 units, you’ll end up paying $50 in spreads every month – just to enter trades. Factor this in over a year period, and you’ll see why spread costs are important.
Here's a table that will help you understand the possible impact:
| Trades / Month | Avg Spread Cost | Monthly Cost | Annual Cost |
|---|---|---|---|
| 20 (Swing Trader) | $2.50 | $50 | $600 |
| 50 (Active Trader) | $2.50 | $125 | $1,500 |
| 100 (Day Trader) | $2.50 | $250 | $3,000 |
Fixed vs Variable Spreads in CFD Trading
CFD brokers generally offer two main spread structures: fixed and variable spreads.
Fixed spreads usually stay constant, even during volatile markets, but variable spreads fluctuate based on liquidity and volatility. So, fixed spreads are great if you want more predictability, so you know exactly what you'll pay to enter a trade at any time.
Variable spreads, on the other hand, adjust to market conditions in real time. During normal trading hours, when liquidity is good, they tend to be narrower than fixed spreads. So, if you only really trade during peak trading hours and prefer highly liquid assets, you’ll probably save more with variable spreads.
Understanding CFD Pricing and Spreads
Because CFDs are derivatives, their price comes directly from the underlying instrument's price. When the underlying instrument increases in value, so does the CFD. However, the broker applies a spread to the market price, which creates the buy and sell prices you see on your trading platform.
But the spread costs aren't just randomly chosen. Brokers receive their pricing from liquidity providers across global financial markets. Then, they need to account for the cost of hedging client trades and managing their risk.
How Spreads Affect Margin Requirements in CFD Trading
When opening a CFD position, your broker will calculate your margin requirement on the value of the open position. So, the spread directly affects how quickly your newly opened position moves into either profit or loss, which in turn impacts your margin available for trading.
Different brokers calculate margin requirements differently, based on the asset type. So, some share CFDs may require 10% account margin, but Forex CFDs may only need less than 5% margin.
Managing CFD Positions Across Global Markets
Because of the truly global nature of the financial markets, spreads for different CFDs vary throughout the day. Generally, the more liquid an asset, the tighter the spread.
So, if you're trading CFDs on a stock, but the market for the underlying asset is closed, there may not be much liquidity, and the spreads may widen. The same concept applies to Forex CFDs too. If you're trading Asian currencies during Asian market hours, spreads may be wider. The same applies for other markets like Europe and the USA. If you want to trade less liquid instruments like exotic currencies, you'll also general have to navigate wider spreads.
Knowing which assets are most liquid – and when makes it easier to plan your trading schedule so you can trade around these times, when spreads are tighter, and costs lower.
Risk Management Strategies for CFD Spreads
Experienced traders know they need to factor spread costs into their risk management strategies. For example, you may only want to take trades that offer a risk-to-reward of 3:1 or more. But have you factored the spread cost into this? If so, is it still within your risk-to-reward ratio?
The same idea applies to other risk management guidelines, like position sizing. If you want to limit your position sizing to no more than 1% of your capital per trade, have you considered how spread costs eat into your initial capital?
One of the best ways to manage your trading costs is to trade the same assets and understand how spread costs change during different times of the day.
It's one thing to have risk management rules in place. It's another thing to factor in all costs before you enter each trade.
Choosing the Right Broker When You Open an Account
When you're ready to start trading and open an account with a CFD broker, you need to consider the spread costs. The best way to go about this is to identify the assets you want to trade and how often you want to trade. Then, check the cost per trade. You may not be able to get the exact cost, as some CFDs may have variable spreads.
Then, run an estimated calculation based on how often you think you will trade. It's worth noting that brokers often have different account options with different cost structures. Some may offer no commission on trades, but a wider spread. Others may have a small commission per trade, but with tighter spreads. It's also a good idea to trade with a demo account first to get a feel of all the costs involved in opening and closing CFD trades.
Factor in Spread Costs and Find Your Edge
Spreads are a non-negotiable cost to trading CFDs. Once you understand and accept this, you can work to mitigate their impact on your account. They should be factored into your risk management rules, guidelines and risk-to-reward calculations so you enter a trade with all the data at your disposal.
Also, don't be afraid to use a demo account for as long as you need to feel comfortable that you're familiar with the trading costs, the instruments you're trading and how the spreads change over time.
Lastly, consider sticking to more liquid assets, and trade them when they are most traded. This is one of the easiest and simplest ways to reduce spread costs.
Remember, being a successful CFD trader is not necessarily in the flashy strategies or new ideas. It's almost always in the mundane things which reduce cost and manage risk.
