CFD stands for contract for difference. CFDs are a form of derivative trading. they derive their value from the movement of an underlying asset. They allow traders to trade price movements without actually owning the underlying asset.
When traders choose to trade CFDs, it means that they are engaging in a contract between themselves and the broker. The trader the “buyer” and the broker the “seller” agrees to a contract that speculates on the price of an asset in market conditions. The security underlying the CFD can be a stock, stock index, currency, commodity, or cryptocurrency.
CFDs trade on leverage, meaning you can enter a trade with a smaller initial outlay of capital. With CFD trading, you don't buy or sell the underlying asset (for example a physical share, currency pair, or commodity). Instead, you buy or sell a number of units for a particular financial instrument, depending on whether you think prices will go up or down.
A good thing about CFDs is that they give you a wide range of trading opportunities. Whatever markets or asset classes you have in mind, chances are that you will find CFD trading opportunities for each. Just to name a few:
◾Single stocks
◾Forex
◾Stock indexes
◾Commodities (metals, energy, etc)
◾Bonds
◾Options
◾Cryptos
Contracts for difference (CFDs) are a leveraged product. Trading with leverage means using capital borrowed from a broker when opening a position. which means that you only need to deposit a small percentage of the full value of the trade in order to open a position. This is called ‘trading on margin’ (or margin requirement). While trading on margin allows you to magnify your returns, your losses will also be magnified as they are based on the full value of the position.
Sometimes traders may wish to apply leverage in order to gain more exposure with minimal equity as part of their investment strategy. Leverage is applied in multiples of the capital invested by the trader, for example, 2x, 5x, or higher, and the broker lends this sum of money to the trader at the fixed ratio. Leverage may be applied to both buy (long) and short (sell) positions. It is important to note that any losses and profits will be multiplied.
Trading on margin CFDs typically provides higher leverage than traditional trading. Standard leverage in the CFD market can be as low as a 2% margin requirement and as high as a 20% margin. Lower margin requirements mean less capital outlay and greater potential returns for the trader.
CFD trading enables you to sell (short) an instrument if you believe it will fall in value, with the aim of profiting from the predicted downward price move. If your prediction turns out to be correct, you can buy the instrument back at a lower price to make a profit. If you are incorrect and the value rises, you will make a loss.
CFDs trade over-the-counter (OTC) through a network of brokers that organize the market demand and supply for CFDs and make prices accordingly. In other words, CFDs are not traded on major exchanges such as the New York Stock Exchange (NYSE). The CFD is a tradable contract between a client and the broker, who are exchanging the difference in the initial price of the trade and its value when the trade is unwound or reversed.
Most CFD trades have no fixed expiry date, meaning that the CFD contract length is unlimited. A trade is closed only when placed in the opposite direction, i.e. you can close a buy trade on 100 CFDs on silver only by selling these CFDs.
CFDs are traded in standardized contracts (lots). The size of an individual contract varies depending on the underlying asset being traded, often mimicking how that asset is traded on the market.
What are the different features of CFD trading and share trading?
| CFDs | Stock |
|---|---|
| Trade using leverage | Pay the full value of your shares upfront |
| Go long or short | Short selling is more complicated |
| Not owning stock | Owning |
| Multiple markets | Equities and ETFs |
| Spread & Rollover | Commission |
| No Voting Rights | Has a Voting Rights |
| OTC | Trading on exchanges |
| No expiry dates | No expiry dates |
Hedging your physical portfolio with CFD trading
If you have already invested in an existing portfolio of physical shares and think they may lose some of their value over the short term, you can use a CFD hedging strategy. By short-selling the same shares as CFDs, you can try and make a profit from the short-term downtrend to offset any loss from your existing portfolio.
For example, say you hold Apple shares in your portfolio; you could hold a short position or short sell the equivalent value of your stocks with CFDs. Then, if Apple’s share price falls in the underlying market, the loss in value of your physical share portfolio could potentially be offset by the profit made on your short-selling CFD trade. You could then close out your CFD trade to secure your profit as the short-term downtrend comes to an end and the value of your physical shares starts to rise again.
Profit and loss
To calculate the profit or loss earned from a CFD trade, you multiply the position (total number of contracts) by the value of each contract (expressed per point of movement). You then multiply that figure by the difference in points between the price when you opened the contract and when you closed it.
When the contract is closed you will receive or pay the difference between the closing value and the opening value of the CFD and/or the underlying asset(s). If the difference is positive, the CFD provider pays you. If the difference is negative, you must pay the CFD provider.
Traders should only consider trading in CFDs if you wish to speculate, especially on a very short-term basis, or if you wish to hedge against exposure in your existing portfolio, and if you have extensive experience in trading, in particular during volatile markets, and can afford any losses. CFDs are not suitable for ‘buy and hold’ trading. They can require constant monitoring over a short period of time (minutes/hours/days). Even maintaining your investment overnight exposes you to greater risk and additional costs. The volatility of the stock market and other financial markets, together with the extra leverage on your investment, can result in rapid changes to your overall investment position. Immediate action may be required to manage your risk exposure, or to post additional margin.
As with every investment, there are risks involved in CFD trading. The primary risk of any type of trading is market risk. If the market moves in the direction you traded, you will make money, if it moves against you, you will lose money. However, because CFDs benefit from leverage, these losses can be more extreme when compared to your initial investment, which is why it is important to always use leverage with care.
The content published above has been prepared by CFI for informational purposes only and should not be considered as investment advice. Any view expressed does not constitute a personal recommendation or solicitation to buy or sell. The information provided does not have regard to the specific investment objectives, financial situation, and needs of any specific person who may receive it, and is not held out as independent investment research and may have been acted upon by persons connected with CFI. Market data is derived from independent sources believed to be reliable, however, CFI makes no guarantee of its accuracy or completeness, and accepts no responsibility for any consequence of its use by recipients.