What is a CFD?
A CFD, also known as a contract for difference dictates that a buyer will pay the seller the difference between the current value of a specific asset and its value at the time of initiating the contract. Contracts for difference allows market participants the opportunity to generate profits simply from price movements without owning the actual asset.
CFDs are over-the-counter products and do not require an exchange or an underlying asset to be associated with the contract.
How CFDs work?
Essentially, CFDs represent an agreement between the investor and the trading provider or broker to exchange the difference in the price of a financial product between the time it was opened and the time it was closed.
With CFDs, there are no deliveries and no underlying assets owned by any party. Simply put, it’s about speculating on the actual price itself and nothing else. For example, instead of buying physical Gold, believing that it’s increasing in value, a trader can buy a CFD on Gold (Figure 1) and close it at a later date, when suitable for them.
CFD regulations by country
Given their nature, contracts for difference are not allowed in certain countries as they compete with other available trading products. A major example is the US where CFDs are not allowed but traders have different options to choose from for their trading and investing needs. It’s worth mentioning that only residents are not allowed to trade them but non-residents are not forced to follow this rule.
On the other hand, CFDs are allowed in countries such as Germany, United Kingdom, Switzerland, France, and many others.
Australia allows CFDs but has recently made changes in relation to the available leverage in order to protect traders, especially those who are new in the market from the obvious risks present in the markets. This is becoming a trend in other countries where regulators are playing a stronger role in protecting consumers.
Figure 1 – 5-minute Gold CFD chart
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Cost of CFDs
The cost associated with trading CFDs may include an added commission, swaps or financing costs, and the spread of an instrument. At CFI, we offer accounts with zero commissions where the cost of trading is embedded in the spread and accounts with very tight spreads but an added minor commission.
Usually, there is no extra cost when trading FX and commodities but other products such as stocks may include the above-discussed commission as a separate charge.
Advantages of trading CFDs
Leverage
Contracts for difference are leveraged products which means you can control a relatively large position with a small amount of money. Not too long ago, the CFDs market was a highly leveraged one with margins going as low as 1% and in some instances even lower but as regulators broadened and strengthened their oversight, mainly for reasons related to the consumers, the leverage for such products dropped across most countries offering it. Nowadays, you can control up to 20 or 30 times the money you have in your account.
The drop in leverage available helps protect traders from the adverse market conditions expected on a near-daily basis. The markets can be volatile and new traders may be tempted by early gains brought upon by beginner’s luck only to lose it later when their expectations on certain instruments fail.
Global access
Most trading providers offer a wide range of CFDs on different global products which means you can have broad access from one single platform. The available assets include currencies, stocks, commodities, indices, and ETFs (Figure 2) with thousands of products associated with them.
No shorting restrictions
Shorting or selling stocks has always been a controversial topic for equity traders but with CFDs, there are no restrictions associated with this practice. You can buy or sell as you please.
A small minimum deposit required
CFDs trading does not require large sums of money from traders to start opening positions. In fact, the available leverage plays an important role in allowing small margin requirements for positions. This is not to say that small investments are necessarily a good approach. It’s important to have enough equity to withstand volatility and adverse market conditions regardless of the required margin to open a position. A general rule of thumb is to start trading small sizes with at least $2500 to $5000 and familiarizing yourself with the potential profit and loss swings that could take place.
Figure 2 – Daily SPY ETF CFD chart
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Disadvantages of trading CFDs
There are no serious disadvantages associated with trading CFDs if one is aware of all the risks present. The common risks include using leverage which allows you to initiate positions that are bigger in size than your capital and the potentially volatile market conditions that could trigger large price swings. The combination could mean large profits and large losses, depending on the outcome of each trade.
Popularity of CFDs
While the product itself has experienced a boom in the past 10 years, the Covid-19 pandemic led to many people working from home amid global lockdowns. This led to a rise in those looking to find activities that would help pass the time while building extra income while others who became victims of the economic downturn took to trading as a new mean of generating income while at home. Furthermore, the pandemic brought upon bouts of volatility across many popular trading products which helped increase trading activities amid seasoned as well as beginner traders.
CFDs as a viable long term trading product
While the majority of traders tend to focus on generating short-term and quick returns by going in and out of the markets quickly, some traders may focus on building positions that will be held for months and even years. There are a few disadvantages here is that CFDs may incur overnight charges which makes them expensive to hold in the long run. Furthermore, they are not products that generate dividends which means the only way you can make money from them is by betting on a specific direction and eventually being right about it. Such disadvantages discourage traders from looking at them as a long-term product unless their strategy’s probability and success rate are profitable enough to cover the downfalls of not generating any extra income and possibly paying overnight fees.
Ideas for successful CFD trading
Trading CFDs is similar to speculating or investing in any other product. You select an asset and decide whether to buy or sell depending on your directional opinion. A few things to keep in mind including implementing a trading strategy or even a basic form of technical analysis which will help you better plan expectations while timing your entry. Another thing to keep in mind is the leverage employed which means it's best to trade smaller positions if your account is small and never risk more than a small percentage of your account per trade. The idea is to treat CFD trading as a business and doing so means cutting your losses when the situation does not pan out the way you expect it.
Other ideas include watching the news for any economic releases or events that could spark volatility and affect your current position or outlook in a certain market. Also, keeping trades for a shorter period of time may be wise given the overnight charges applied on CFD trading. Focusing on all those elements can help traders gain a better understanding towards a successful trading journey.
One final point to keep in mind is the availability of demo accounts. Having this privilege means practicing with no risk to your money and a demo account can help you control your emotions, establish a solid trading strategy and understand the right risk parameters when trading certain markets. It’s a vital tool for anyone looking to get started or is already a seasoned trader interested in sharpening their trading strategy further.
Demo accounts are typically available for 1 month before expiring although most providers offer them for an unlimited period of time nowadays. Practicing on a demo should not be a short endeavor and should extend at least 1-3 months to get truly comfortable with the markets. The next step would be to start your account with a small deposit and trade the smallest sizes possible. Emotions including greed become a serious issue when real money is involved, especially money that you cannot afford to lose if you had deposited a bigger amount in the hopes of making large profits and over a short period of time. The idea of getting rich quickly should never be a goal as trading is a business and any business no matter how fast it grows, should be maintained without over-expecting success.
Example of a trade in CFDs
Imagine you have been watching a stock priced at $25.00 (bid $24.98/ask $25.00) and you believe the company’s latest product is likely to be a hit among consumers.
You decide to buy 100 shares for an order value of $2500.
Of course, given the available leverage, the trade will require from you a smaller amount in terms of margin.
If the stock moves higher, you will be generating an unrealized profit.
Let’s say it has reached your target of $28.00 and you decide to close the trade.
You decide to close the position for a profit of $3 per share.
In this case, your total profit will be $3 x 100 = $300.
The example above is oversimplified and hypothetical in nature.
Now let’s take a look at another example:
Let’s say you are watching a stock priced at $100 (bid $100/ask $100.02) and you are expecting higher prices after a recent breakout to the upside.
You decide to buy 10 shares valued at $1000.
Again, given the available leverage, the trade will require from you a smaller amount in terms of margin.
The market moves a bit higher before reversing lower and creating a false breakout pattern.
The stock is now trading at $85.
You decide to close the trade for a loss of $15 per share.
In this case, your total loss will be $15 x 10 = $150.