Contract for Differences (CFD)
A contract for differences (CFD) is a contract between a buyer and a seller that stipulates that the buyer must pay the seller the difference between the current value of an asset and its value at contract time. CFDs allow traders and investors an opportunity to profit from price movement without owning the underlying assets. The value of a CFD does not consider the asset’s underlying value, only the price change between the trade entry and exit.
This is accomplished through a contract between client and broker and does not utilize any stock, forex, commodity, or futures exchange. Trading CFDs offers several major advantages that have increased the instruments’ enormous popularity in the past decade.
There is no delivery of physical goods or securities with CFDs. A CFD investor never actually owns the underlying asset but instead receives revenue based on the price change of that asset. For example, instead of buying or selling physical gold, a trader can simply speculate on whether the price of gold will go up or down.
Essentially, investors can use CFDs to make bets about whether or not the price of the underlying asset or security will rise or fall. Traders can bet on either upward or downward movement. If the trader who has purchased a CFD sees the asset’s price increase, they will offer their holding for sale. The net difference between the purchase price and the sale price are netted together. The net difference representing the gain from the trades is settled through the investor’s brokerage account.
On the other hand, if the trader believes that the asset’s value will decline, an opening sell position can be placed. To close the position, the trader must purchase an offsetting trade. Then, the net difference of the loss is cash-settled through their account.
Countries Where You Can Trade CFDs
CFDs are not allowed in the United States. They are allowed in listed, over-the-counter (OTC) markets in many major trading countries, including the United Kingdom, Germany, Switzerland, Singapore, Spain, France, South Africa, Canada, New Zealand, Sweden, Norway, Italy, Thailand, Belgium, Denmark, and the Netherlands, as well as the Hong Kong special administrative region.
As for Australia, where CFDs are currently allowed, the Australian Securities and Investments Commission (ASIC) has announced some changes in the issue and distribution of CFDs to retail clients.
The Costs of CFDs
The costs of trading CFDs include a commission (in some cases), a financing cost (in certain situations), and the spread—the difference between the bid price (purchase price) and the offer price at the time you trade.
There is usually no commission for trading forex pairs and commodities. However, brokers typically charge a commission for stocks. For example, the broker CMC Markets, a U.K.-based financial services company, charges commissions that start from 0.10%, or $0.02 per share, for U.S.- and Canadian-listed shares.
A financing charge may apply if you take a long position. This is because overnight positions for a product are considered an investment (and the provider has lent the trader money to buy the asset). Traders are usually charged an interest charge on each of the days that they hold the position.
For example, suppose that a trader wants to buy CFDs for the share price of GlaxoSmithKline. The trader places a £10,000 trade. The current price of GlaxoSmithKline is £23.50. The trader expects that the share price will increase to £24.80 per share. The bid-offer spread is 24.80–23.50.
The trader will pay a 0.1% commission on opening the position and another 0.1% when the position is closed. For a long position, the trader will be charged a financing charge overnight (normally the LIBOR interest rate plus 2.5%).
The trader buys 426 contracts at £23.50 per share, so their trading position is £10,011. Suppose that the share price of GlaxoSmithKline increases to £24.80 in 16 days. The initial value of the trade is £10,011, but the final value is £10,564.80.
The trader’s profit (before charges and commission) is as follows:
£10,564.80 – £10,011 = £553.80
Since the commission is 0.1%, the trader pays £10 upon entering the position. Suppose that interest charges are 7.5%, which must be paid on each of the 16 days that the trader holds the position (426 × £23.50 × 0.075/365 = £2.06. Since the position is open for 16 days, the total charge is 16 × £2.06 = £32.92.).
When the position is closed, the trader must pay another 0.01% commission fee of £10.
The trader’s net profit is equal to profits minus charges:
553.80 (profit) – 10 (commission) – 32.92 (interest) – 10 (commission) = £500.88 (net profit)
Advantages of CFDs
Higher Leverage
CFDs provide higher leverage than traditional trading. Standard leverage in the CFD market is subject to regulation. It once was as low as a 2% maintenance margin (50:1 leverage) but is now limited in a range of 3% (30:1 leverage) and could go up to 50% (2:1 leverage). Lower margin requirements mean less capital outlay for the trader and greater potential returns. However, increased leverage can also magnify a trader’s losses.
Global Market Access from One Platform
Many CFD brokers offer products in all of the world’s major markets, allowing around-the-clock access. Investors can trade CFDs on a wide range of worldwide markets.
No Shorting Rules or Borrowing Stock
Certain markets have rules that prohibit shorting, require the trader to borrow the instrument before selling short, or have different margin requirements for short and long positions. CFD instruments can be shorted at any time without borrowing costs because the trader doesn’t own the underlying asset.
Professional Execution with No Fees
CFD brokers offer many of the same order types as traditional brokers, including stops, limits, and contingent orders, such as “one cancels the other” and “if done.” Some brokers offering guaranteed stops will charge a fee for the service or recoup costs in another way.
Brokers make money when the trader pays the spread. Occasionally, they charge commissions or fees. To buy, a trader must pay the ask price, and to sell or short, the trader must pay the bid price. This spread may be small or large depending on the volatility of the underlying asset; fixed spreads are often available.
No Day Trading Requirements
Certain markets require minimum amounts of capital to day trade or place limits on the number of day trades that can be made within certain accounts. The CFD market is not bound by these restrictions, and all account holders can day trade if they wish. Accounts can often be opened for as little as £1,000, although £2,000 and £5,000 are common minimum deposit requirements.
Variety of Trading Opportunities
Brokers currently offer stock, index, treasury, currency, sector, and commodity CFDs. This enables speculators interested in diverse financial vehicles to trade CFDs as an alternative to exchanges.
Disadvantages of CFDs
Traders Pay the Spread
While CFDs offer an attractive alternative to traditional markets, they also present potential pitfalls. For one, having to pay the spread on entries and exits eliminates the potential to profit from small moves. The spread also decreases winning trades by a small amount compared to the underlying security and will increase losses by a small amount. So, while traditional markets expose the trader to fees, regulations, commissions, and higher capital requirements, CFDs trim traders’ profits through spread costs.
Weak Industry Regulation
The CFD industry is not highly regulated. A CFD broker’s credibility is based on reputation, longevity, and financial position rather than government standing or liquidity. There are excellent CFD brokers, but it’s important to investigate a broker’s background before opening an account.
Risks
CFD trading is fast-moving and requires close monitoring. As a result, traders should be aware of the significant risks when trading CFDs. There are liquidity risks and margins that you need to maintain; if you cannot cover reductions in values, then your provider may close your position, and you’ll have to meet the loss no matter what subsequently happens to the underlying asset.
Leverage risks expose you to greater potential profits but also greater potential losses. While stop-loss limits are available from many CFD providers, they can’t guarantee that you won’t suffer losses, especially if there’s a market closure or a sharp price movement. Execution risks also may occur due to lags in trades.