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It is believed that contracts for difference or CFDs were first created in the United Kingdom (UK) in the 1990s. Supposedly, a financial services business in London created this financial tool for hedging purposes.
Fast forward to today, CFDs are among the popular ways of trading for people seeking leverage in their trading portfolios. However, despite this tool’s popularity, many people still need to learn what CFDs are and how they work.
This article introduces CFDs and explains how this trading instrument allows investors to speculate on a security’s price movements.
It discusses the reasons behind its popularity and the disadvantages of CFD trading.
This article provides you with the information you need, including trading terms and examples of a CFD trade, to help you on your CFD trading journey.
What Is a Contract for Difference (CFD)?
A contract for difference is an agreement between two parties to trade financial instruments like stocks, bonds, indices and options based on the price difference between the opening and closing prices.
CFDs are financial derivatives because you don’t own any asset, and you’re investing in what derives from the performance of an asset in the market, like the value of the opening price versus the closing price.
On the other hand, CFD trading is speculating on market price movements without owning an asset. Using CFDs, a trader bets on whether the price of the underlying asset rises or falls at a given date in the future.
Understanding the Building Blocks of CFD
The building blocks of CFDs are financial instruments, the parties involved, the strike price, and the market price.
CFDs allow investors to earn a profit if the strike price exceeds the market price at an agreed time. Likewise, traders will lose money if the market price exceeds the strike price when the contract ends.
The market price is the price at which the contract (CFD) is bought or sold. The current price is also called the spot price.
The market price fluctuates according to external conditions influencing the supply and demand for the option. On the other hand, the strike price is fixed and predetermined.
Key Takeaways
- Contracts for difference are agreements between parties to trade financial instruments based on the difference between opening and closing prices.
- CFDs have become a popular alternative for traders because they can access underlying assets at a lower cost without owning an asset or buying the entire asset value.
- CFDs are currently prohibited in the United States partly because CFDs don’t pass through regulated exchanges.
However, CFDs are permitted, but strictly regulated in registered OTC (over-the-counter) markets in major trading countries like the United Kingdom, Switzerland, France, Singapore, Hong Kong and Australia.
CFDs are also allowed in EU countries in the European zone, like France, Germany, Italy and Spain.
How Contracts for Difference (CFDs) Work
CFDs may be confusing, leading new traders to make wrong decisions, resulting in money loss. Investors, especially beginner traders, should understand CFDs fully before entering the markets.
With CFD, you don’t have to deliver physical goods or securities. CFD investors don’t even have to own the underlying asset.
Instead, the CFD trader speculates on the performance of an asset, essentially betting on whether the price rises or falls at a given date in the future. An accurate prediction results in profits, while a wrong guess means a potential loss.
How Are Contracts for Difference Designed?
CFDs are designed to promote investments in a particular financial market. The example above shows that a government can use CFDs to incentivise large-scale renewable projects according to targets.
Policymakers and regulators also designed the CFD scheme to combine renewable assets into power markets while avoiding market distortion.
Distortion occurs when something other than the natural forces of supply and demand influence goods and services market prices.
How Do Contracts for Difference Apply to the Markets?
CFDs apply to the market in a few different ways:
- CFDs can incentivise investments similar to what the United Kingdom has done with renewable energy.
- CFDs are cash-based or rely on cash settlements, as traders don’t need to own assets.
These market applications of CFDs have become one of the popular trading options for experienced investors.
Countries Where You Can Trade CFDs
CFDs are currently not allowed in the United States. However, this type of derivative trading is permitted in over-the-counter (OTC) markets available in the following countries:
- Australia
- Belgium
- Canada
- Denmark
- France
- Germany
- Hong Kong
- Italy
- New Zealand
- Norway
- Singapore
- South Africa
- Spain
- Sweden
- Switzerland
- Thailand
- The Netherlands
- The United Kingdom
The Costs of CFDs
CFD trading costs include commissions in cases where it applies, financing costs and the spread. The spread is the difference between the purchase or bid price and the offer price when you start the trade.
There may be other miscellaneous costs in CFD trading, which you can discuss with your CFD broker of choice.
Example
CFD trading charges come in commissions, interest rates and spread. Here’s an example to better understand these charges:
Let’s say a CFD trader wants to buy CFDs for the share price of ABC company. The share price of ABC company starts at £10 during the opening and expects it to increase to £15 in 10 days.
Now, let’s say the trader buys 100 contracts of ABC at £10 per share, which equals £1,000. If the trader is correct, after 15 days, the final value of the trade is now £1,500.
Now, let’s calculate the CFD trader’s net profit. Consider that the commission is 0.1% at the opening and closing value, and the interest rate is 10%.
Here’s how to calculate the daily interest rate:
Interest = (number of contracts) x (share price) x (interest rate/365 days) x (time period)
Interest = 100 x £10 x (0.10/365) x 15
Interest = £4.00
To calculate the net profit of a CFD trader spread betting on CFDs, you can use the following formula:
You can start by calculating the gross profit by subtracting the lesser value from the bigger one.
£500 (gross profit) = £1,500 (closing trade price) – £1,000 (opening trade price)
Next, subtract the cost from the gross profit to get the net or actual profit.
Net Profit = gross profit – opening commission – interest – closing commission
Net Profit = £500 – £10 – £4 – £10 = £476
In this example, the CFD trader’s net profit from trading is £476.
Can You Make Money With CFDs?
As a CFD trader, you can make money with CFDs if the strike price exceeds the market price at the agreed-upon date. However, you lose money if the strike price dips lower than the market price.
Advantages of CFDs
The United Kingdom dominates the CFD market, with over 275,000 CFD traders in 2021. Statistics show that for CFD providers and traders, using this derivative option has its advantages.
Here are some of the advantages of CFDs:
Higher Leverage
CFDs have higher leverage than traditional trading. Leverage in CFD trading is the ability to trade without paying the entire asset’s value. The trader can pay only a fraction of the total value or a margin.
Global Market Access From One Platform
CFD brokers offer traders access to products in every major CFD market. Traders can choose from a wide range of worldwide markets to trade without the burden of buying entire securities.
Shorting Rules or Borrowing Stock
Some markets prohibit practices like requiring the trader to borrow an instrument and then sell short or have different margin requirements for long and short positions.
Still, CFDs can be “shorted” anytime without borrowing because traders don’t own any underlying asset.
Professional Execution
CFD brokers offer services that traditional brokers provide. Service brokers provide limits, stops and contingent orders. Some brokers offer guaranteed stops for a fee.
No Day Trading Requirements
CFD markets don’t have day trading restrictions. CFD traders can day trade anytime and open accounts for as little as £100. The standard minimum deposit requirements in the market are £100 to £500.
Variety of Trading Opportunities
CFD trading offers a variety of trading opportunities by allowing speculation in diverse financial asset classes like the following:
- Stocks
- Indices
- Treasury
- Currency
- Commodity
- Metals
- Futures contracts
Disadvantages of CFDs
Like any investment product, CFDs can be risky.
So, before you commit your capital, you must be aware of the risks of trading complex financial products like CFDs.
Risks
CFDs are fast-moving and demand careful monitoring. Moreover, you need to maintain margins while managing liquidity risks.
Once you can’t cover value reductions, your CFD provider may close your position, and you’ll have to incur a loss. So, arm yourself with education and experience and lower the risks to something you can manage.
Are CFDs Illegal?
Although heavily monitored and imposed with regulatory restrictions, CFDs are allowed in many countries, including the United Kingdom and other European Union countries.
However, CFD trading is prohibited entirely in the United States because it is against the country’s securities law.
Is Trading CFDs Safe?
As mentioned above, CFD trading always has risks involved. Still, you can enhance your risk management strategy to help minimise potential loses.
Example of a CFD Trade
Let’s say a CFD trader purchases 100 shares of a stock with an “ask price” of £25.26 each. The total cost is £2,526, excluding charges.
If the trader goes with a regular broker using a 50% margin, for example, the trader needs to pay half of the total cost to trade.
With CFDs, the trader doesn’t have to pay the total cost of £2,526. Let’s say the CFD broker uses a 5% margin. In that case, the trade will only pay 5% of the total cost, which is £126.30.
To profit, the CFD trader must ensure that the stock price rallies to the bid price or offer price.
Common Terms for Contracts for Difference
Sometimes, trading jargon can dampen one’s eagerness to get into trading. However, once you start learning the language used in trading, CFD trading terms will slowly no longer look Greek.
Trading Terms: Going Long vs Going Short
Going long: When traders open a CFD position in anticipation that an underlying asset’s price will rise, they’re going long or trading on the long side.
Going short: When traders open a CFD position in anticipation that an underlying asset’s price will decrease, they’re trading from the sell side or going short.
Relationship Between Margin and Leverage
When you want to invest in CFD trading, you don’t need to deposit the total value of a security to open a position. Instead, you can deposit a portion of the total amount. This partial deposit is known as the “margin.”
Because of the margin, CFDs are considered leveraged investment products. However, leveraged investments can amplify price gains or losses in the underlying asset for investors.
Terms Related to the Cost of CFD Trading
Here are other terms you may encounter when trading with CFDs.
- Spread: This is the difference between a security or asset’s ask and bid prices for a security or asset. Note that the difference between the ask and bid price is subtracted from the gross profit or included in the overall loss.
- Holding costs: These are charges incurred by the trader over open positions at the end of a trading day. It may have positive or negative charges depending on the spread direction.
- Commission charges: The CFD broker often charges this for the share trading activity.
- Market data fees: You pay these costs to a broker when they help you gain exposure to CFD trading services.
References
- Contract for Differences (CFD) Definition, Uses, and Examples
https://www.investopedia.com/terms/c/contractfordifferences.asp
2.Derivatives: Types, Considerations, and Pros and Cons
https://www.investopedia.com/terms/d/derivative.asp
3.Contract for Difference (CfD)
https://www.iea.org/policies/5731-contract-for-difference-cfd
4.CFD leverage and margin
https://www.forex.com/en-ca/trading-academy/courses/mastering-cfds/cfd-leverage-and-margin/
Disclaimer: The information provided in this article is for general informational purposes only and does not constitute financial advice. It is not intended to be a recommendation to buy or sell any financial instrument or engage in any investment activity.
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