What is a Contract for Difference (CFD)?
A contract for difference (CFD) is a financial derivative that allows traders to speculate on the price direction of an underlying asset without actually having to own the asset.
A CFD is a contract between a trader and a CFD provider, which is typically a brokerage firm. The contract stipulates that the buyer will pay the difference between the price of the asset when they open the trade and the price when they close the trade if the price decreases, and the seller will pay the difference if the price increases.
The trader opens a long “buy” position if they expect the price to rise and opens a short “sell” position if they expect the price to fall.
3 Characteristics of CFDs
There are three main characteristics of CFDs:
- CFDs Allow Traders to Go Long or Short: When buying a stock, currency, or other asset outright, a trader only profits if the price moves higher. But a CFD is one way a trader can short an asset if they expect the price to fall and still make a profit when the price moves lower.
- CFDs are Leveraged Instruments: CFDs enable traders to increase their exposure to the market using a small initial deposit. They effectively pay a percentage of the cost of the position as a margin. However, it is important to note that profits and losses on the position are magnified, as they are based on the full size of the position and not only the margin.
- CFDs Follow the Direction of the Underlying Asset: CFDs are designed to track the direction of the underlying market. This is what allows traders to speculate on the asset price without owning the asset.
Why Trade CFDs?
There are several advantages to trading CFDs rather than simply trading the underlying asset they represent. These include:
- Market Access: CFDs allow users to trade assets that can be difficult to own, such as physical commodities, which require delivery and storage, or cryptocurrencies, which require a separate exchange account and digital wallet. For example, instead of buying physical coins, bars, or bullion and paying for secure storage, a trader can simply trade a CFD to speculate on whether the gold price will rise or fall.
- Leverage: By using leverage, traders can increase their exposure to an asset while paying only a percentage of the value of a position.
- Flexibility: Traders can profit regardless of the direction of the markets by taking long or short positions.
- Tax benefits: Trading CFDs can offer some tax benefits because the trader does not own the underlying asset.
- Hedging: CFDs are useful hedging tools as you can offset losses against profits for your capital gains tax (CGT) liabilities.
- Longer Hours: CFDs allow you to trade some assets outside of regular trading hours, although some market prices can differ significantly from their out-of-hours values.
How Do CFDs Work?
CFDs are advanced trading instruments that should be used by experienced traders, as the use of leverage can result in hefty losses.
CFD platforms quote two prices – a sell price (bid) and a buy price (ask). The difference between the two prices is known as the spread. The buyer pays the higher price, the seller receives the lower price, and the broker receives the difference.
Trading CFDs requires two trades. If the trader expects the price of the underlying asset to rise, they open a buy position. Once the price moves higher, they close the position with a sell trade.
Conversely, if the trader expects the asset’s price to decline, they open a sell position and close the position with a buy trade. The difference between the two prices is cash-settled through their brokerage account.
The trader’s net profit or loss is the price difference less any commission or margin interest.
How to Trade CFDs
Here’s a basic step-by-step breakdown of how CFD trading works:
- Choose the Asset: Decide which financial asset to trade. This could be a stock, index, currency pair, commodity, or any other asset offered by your CFD provider.
- Select Your Position: Choose whether you want to hold a long or short position, depending on your expectations for the market.
- Determine the Trade Size: Select the size of the CFD position you want to take. This is typically measured in lots or contracts.
- Set Your Leverage: CFDs often provide different levels of leverage, allowing you to take a larger position with a smaller amount of capital. Be cautious with this, as it amplifies losses as well as gains.
- Place the Trade: Execute the trade to initiate the contract with the CFD provider.
- Monitor the Market: Keep an eye on the asset’s price movements and the market drivers that may affect it. You can close your position at any time to take profit or limit your losses.
- Close the Trade: When you are ready to exit the position, you can close the CFD by executing an opposing trade.
- Settle the Difference: The difference in the prices between the opening trade and closing trade is calculated, and your account is credited or debited accordingly.
Advantages and Risks of CFD Trading
Pros of CFD Trading
Cons of CFD Trading
Leverage allows traders to multiply profits with smaller upfront capital investments.
While leverage amplifies gains, it also multiplies losses if the price moves in the opposite direction to the trader’s position.
CFDs provide access to a range of financial markets, enabling portfolio diversification
Sharp price fluctuations can result in traders losing more than their initial deposit.
CFDs allow traders to profit from falling prices by taking short positions.
Positions that are held overnight are subject to overnight financing based on the size of the contract. The trader pays interest on the total exposure, regardless of the margin.
Traders can use CFDs to hedge existing positions, protecting their portfolios against adverse price volatility.
CFD trading costs can add up, including spreads, commissions, and overnight financing fees, reducing traders’ profits.
Traders can speculate on the direction of an asset price without owning the underlying asset.
The regulatory environment for CFD trading varies by country, and choosing an unregulated provider carries risks.
CFDs are not bound by restrictions on the amount of capital required to day trade or limits on the number of day trades that can be made within certain accounts.
Some countries, such as the US, prohibit CFD trading.
Unlike futures contracts, CFDs do not have a fixed expiry date, so traders can keep them open for as long as they want to maximize profits or limit losses.
A CFD holder has no shareholder rights as they do not own the underlying asset.
Why are CFDs Banned in the US?
CFD trading is illegal in the US as The Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) prohibit US residents and citizens from opening CFD accounts on domestic or foreign trading platforms.
This is because CFDs are over-the-counter (OTC) products that are not listed on regulated exchanges.
The use of leverage to allow users to trade on margin has raised concerns among regulators because of the possibility that inexperienced traders can rack up large losses that are bigger than the size of their initial positions.
Is CFD Trading Safe?
Trading CFDs carries higher risks than trading stocks, bonds, and other assets. CFD trading can also be considered risky owing to factors such as poor industry regulation, a potential lack of liquidity, and the need to maintain an adequate margin due to leveraged losses.
Whether CFD trading is safe for you depends on your understanding of those risks, your trading strategy, and the CFD provider you choose.
In some countries, CFD trading is heavily regulated to protect traders, less so in others. It’s safer to trade on CFD platforms that are regulated by financial authorities.
To trade safely with leverage, you should have a clear risk management strategy in place, which may include setting stop-loss orders and only trading with funds you can afford to lose.
You should have a solid understanding of the financial markets and the specific assets you intend to trade with CFDs. It is essential to be cautious and use leverage prudently.
CFDs are versatile leveraged financial instruments that allow traders to speculate on the direction of various asset prices without owning them.
CFDs are popular as they allow users to trade on margin to maximize profits and gain access to a broad range of markets to assist with portfolio diversification and hedging.
However, CFD trading also carries risks that traders should be aware of before risking money.
If you are considering trading CFDs, it’s essential to educate yourself, manage your risk, and choose a trustworthy CFD provider to use them effectively.