If you have ever opened the website of a brokerage company, you inevitably have noticed many of these give clients the option to trade with the so-called contracts for difference (CFDs). This type of derivative is commonly preferred by veteran traders because it offers them numerous advantages.
Our detailed guide tells you anything you may want to know about trading with CFDs. We explain how this type of instrument works, how it is regulated, what markets it is available for, and some of the key concepts you need to understand before you choose a CFD broker. Also covered are the advantages and disadvantages of the instrument.
What Is CFD Trading?
The contract for difference (CFD) is a derivative financial instrument that enables traders to speculate on the price fluctuations of fast-moving markets such as the foreign exchange, indices, soft and hard commodities, bonds, and shares.
Traders can speculate on the rise or fall of market prices without owning any underlying assets like fiat currencies, cryptocurrencies, precious metals, physical shares in a company, natural gas, sugar or crude oil. This speculation is possible in either direction, with traders having the option to open short or long positions.
The losses or profits they realize depend on the extent to which their price-movement predictions are correct. With contracts for difference, the actual value of the underlying assets is not taken into account. Instead, only the changes in the entry and exit values of the prices are considered. In essence, this is a contract between a broker and their customer, hence the name of this instrument.
With CFDs, the trader purchases or sells a given number of units for their preferred market, depending on whether they think the price value of the said market will appreciate or depreciate.
When the trader believes the value of their selected market will rise, they choose to open a buy position. In this case, their earnings will rise proportionately to the increase in the market’s price, i.e. they will earn multiples of the number of CFD units they have purchased.
Unfortunately, the opposite is also true. If the price of the market drops, the trader will register losses for each point with which the price moves against them. Here is a concrete example of how trading with CFDs works.
Suppose a trader believes the value of natural gas will go up, so they decide to open a buy position and purchase ten CFDs for this market at a price of 3525. Provided that the natural gas market rises by twenty points to 3545 and the trader decides to close down their position, they will register a profit of $200. This is twenty times the number of contracts they had initially purchased.
As we said earlier, there is also the possibility of the market moving in the opposite direction, i.e. against the trader. If this happens and the price of natural gas drops by twenty points to 3505, the trader will suffer losses of $200 instead.
6 Key Concepts of CFD Trading
The contract for difference is a more complex and highly volatile trading instrument, which causes most unversed retail traders to part with their accounts’ balance. The instrument requires a good level of understanding or else you risk incurring significant losses. It is no surprise that CFDs are commonly preferred by seasoned traders with sufficient experience and knowledge.
These qualities enable them to make correct predictions about the price movements of different markets. If you are new to trading with this derivative, we recommend you to carefully read the sections that follow to familiarize yourself with six key concepts of this instrument.
Short and Long Positions in CFD Trading
We previously mentioned that those who choose this instrument have the opportunity to trade in two directions, long or short. Trading with CFDs mimics conventional trading in the sense that you realize profits when the value of a market appreciates. In this case, you buy CFD units for a given instrument, which is known as “going long”.
However, it is also possible to earn money when the market’s price diminishes, in which case the trader sells their CFD units. Trading on falling markets is commonly referred to as “going short”.
Here is another hypothetical example. Let’s assume a person decides to use CFDs on the US Tech 100 Index, which is trading at 2450. The person believes the US Tech 100 will drop because they expect the index to underperform in the forthcoming season.
They choose to go short, i.e. open a sell position of 10 CFDs for the US Tech 100 at a price of 2450. The index indeed underperforms and drops down by fifty points to 2400. This causes the trader to close their position and realize profits of $500 from the fifty-point difference in the entry and exit prices for the ten CFDs they have purchased. Regardless of what direction you trade in, you register profits or losses once you close your open buy/sell position.
CFDs and Leverage
The contract for difference is a leveraged product, which enables traders to invest smaller amounts of money to deal with a much larger trading volume. This is known as leverage. Say a trader is interested in opening a position equal to 1,000 shares in Facebook, for example.
In the absence of leverage, this would mean they must cover the entire cost of the Facebook shares upfront. To proceed with the example, the price per share is $1, or 100 x $0.01. In a conventional situation where the person executes a traditional trade with a broker, they will have to pay them 1,000 x $1 upfront.
This would cause them to expose a total of $1,000 to risk, provided that we ignore any additional charges or commissions. If Facebook shares jump by $0.30, the price per share will increase to $1.30.
Upon closing the position, the trader would have turned a profit of $300 from their initial investment of $1,000. Of course, the opposite is also possible. The trader could have lost $300 if the market price of the Facebook shares had dropped by $0.30, which is more than one-third of their original investment.
However, this is not the case if the person decides to open a position for a leveraged product like the CFD where they will have to invest only 10% of their initial $1,000 capital, or $100. Note that these percentages may differ depending on which CFD broker you trade with.
The trader would still realize a profit of $300 when the Facebook price increases to $1.30 per share but this will happen at a significantly lower cost. Provided that the share price moves in an unfavorable direction and drops by $0.30, the person would have ended up losing trice their initial deposit, or $300.
Leverage is great from the perspective of professional traders because it gives them the chance to spread their capital further. However, it is worthwhile noting that leverage is a double-edged sword because brokers calculate both your gains and losses at the full price of your CFD position.
The presence of leverage can considerably magnify the profits or losses CFD traders can incur, so much so that sometimes the financial hit you take may even exceed your original deposit.
CFDs and Margins
Another important concept beginner CFD traders should familiarize themselves with is that of margin. This one is closely linked to the concept of leverage. The margin represents the difference between the money you need to open and maintain a trading position and the actual amount you invest, which is lower when you trade with leverage.
Trading with margin is essentially the same as borrowing money from your CFD broker to cover the higher cost of a trade. You will come across two types of margin when trading CFDs. First, you have a deposit margin, which you must meet before you can even open a given trading position.
Then, you have a maintenance margin. This one is used when an open position gets very close to generating losses that will exceed the deposit margin and the overall available balance you have in your account.
In such situations, your CFD broker would remind you to transfer additional funds to your balance. This is known as a margin call. If you fail to top up your account with a sufficient amount of money, the broker will automatically close down your losing open position. The losses it incurred will be immediately realized, causing your balance to go in the negative.
Spreads and Commissions for CFD Trading
When you trade with this complex instrument, your broker always offers you two prices that depend on the underlying value of your chosen market, the buy or bid price and the sell or ask price.
The buy price is inevitably greater than the actual underlying value of your asset, be it a commodity, a currency pair or an index. The opposite is true for the sell price, which is always lower. The difference between the buy price and the sell price you are offered is known as the spread.
Most brokerages that offer CFD trading do not charge additional commissions for this instrument. There is no need to because they get their share of profits from the spread built into the CFD markets.
However, it is best to check in advance the policies of your chosen CFD broker to inform yourself about potential commissions. Usually, commissions are only charged when you trade shares with CFDs.
Here is an example of how the spread works. Imagine a trader estimates the price of palladium is to jump so they decide to open a long CFD position for this precious metal. The price quoted by their brokerage for this market is $1,405 for buying and $1,400 for selling, which corresponds to a spread of $5. The trading volume they choose is 100 CFDs for palladium, in which case they have to invest 100 x $1,405, or $140,500.
Now, suppose the expectations of this hypothetical CFD trader are met and the value of palladium indeed jumps by $20. Thus, the ask price becomes $1,420 while the bid price increases to $1,425. The profit from this trade will be 100 CFDs x ($1,420 – $1,405), or $1,500.
CFD Contract Sizes
The contract size is another important concept CFD traders must acquaint themselves with before they join a brokerage website. It is based on the underlying assets you speculate with. The contract size usually mimics how the respective asset is traded on the market.
Silver, for example, is often traded in lots of 5,000 troy ounces, with a single troy ounce being the equivalent of 1.09714286 (31.1034768 grams in the metric system). Troy ounces are antiquated units borrowed from the Roman Empire but are still used today to preserve measurement standards over time and prevent problems for the current monetary system.
A CFD for silver will be equal to 5,000 troy ounces. Meanwhile, if you speculate with shares, you usually face a contract size equal to a single share of your chosen company. Thus, if you open a long position for 100 shares of Amazon, you are, in essence, buying a contract for 100 Amazon CFDs.
Other examples of the differences in contact sizes include soft commodities like coffee, which is measured in pounds, and soybeans, which are traded in bushels.
If you have an acquaintance with a professional trader, you might have heard them mention hedging. This approach is implemented by many experienced investors who trade with CFDs. They use it to manage their risk and protect their existing physical portfolio.
Let’s assume our hypothetical trader has $10,000 in Netflix shares and is afraid they must imminently sell them off. The trader can try and protect their portfolio by going short with the sale of $10,000 in Netflix CFDs.
Suppose the prices of Netflix shares drop by 10% in the underlying market because the company reports disappointing earnings. The trader will offset some of their potential losses by realizing profits from their short position.
Hedging will spare them the hassles and the additional expenses associated with having to liquidate their stock holdings. You can also determine your stop and loss limits so that your CFD positions automatically close when they reach your preferred profit or loss level. This is another way to manage your risk when trading CFDs.
4 Common Markets for CFD Trading
One great thing about CFDs is that the instrument can be used across many different types of markets, including trading with Forex currency pairs, indices, stocks, soft and hard commodities, and even bonds. The sections below cover four of the most common options for CFD traders.
Forex CFD Trading
Many experienced investors prefer to trade currency pairs against each other with contracts for difference because this increases their exposure to the Forex market. The latter is the largest and most liquid market in the world, exceeding even the stock market in terms of trading volume.
According to data released by the CLS Group, the market hit a record daily high of $1.8 trillion in the first quarter of 2018 alone, fueled by the massive trading activity in the months of February and June.
Instead of buying and selling currencies in the conventional way on the spot market, you can trade units of currencies depending on whether you think their underlying value will appreciate or depreciate. It works quite similarly to traditional Forex trading. Trading CFDs for this instrument comes with many different benefits. For example, there is no need for you to deposit the full value of your trades.
Another option for CFD traders is to trade commodities. There are two types of those, starting with hard commodities like natural gas, crude oil, and precious metals that are mined.
There are also soft commodities like sugar, orange juice, coffee, cocoa, wheat, corn, livestock and soy that are grown. Note that many of the CFDs for such commodities borrow their prices from the underlying values of the futures market.
Most CFD brokers usually give their clients the option to make contracts for differences on the shares of some of the world’s largest companies. Both long and short positions are available for this market. Contracts normally start at minimum lots of one share. The trading hours coincide with those for the underlying exchange. In most cases, a commission is charged on share CFDs.
Another alternative for CFD traders is to speculate on the performance of different stock markets, including some of the biggest indices in the world, such as Dow Jones, the FTSE 100 Index, Nikkei 225, the German DAX 30, Nasdaq, the Hang Seng Index, and the NYSE.
As a matter of fact, trading index CFDs is the less volatile alternative to trading individual stocks. It enables the trader to spread their risk across an entire market instead of restricting themselves to a single company.
Advantages and Disadvantages of CFD Trading
Contracts for difference are an advanced trading instrument, which can be very beneficial for seasoned traders but at the same time, very detrimental to those who lack experience and proper understanding of how it works. Let’s start with a rundown of some of the main advantages this instrument has to offer.
- The ability to trade with leverage enables you to spread your trading capital and register significant profits with a relatively small investment.
- You earn profits from the price movements of markets without having to own any underlying assets yourself.
- Costs are reduced because most markets available for CFD trading, with the exception of shares, come with no extra commissions. The costs for brokers are usually covered by the built-in spread.
- CFD traders face a huge variety of trading opportunities. Many brokers who offer such contracts provide a choice from currency, commodity, index, stocks, bonds, and treasury CFDs. This ensures speculators have a broad range of financial vehicles to operate with.
As we stressed on several occasions, this is a complex instrument that drains the entire balance of many retail traders. You should carefully examine the pitfalls below before you start your CFD trading experience.
- Remember when we said you can score huge profits with a small capital due to leverage. The bad news is the opposite is also true. Leverage boosts your potential for profits but it also increases your losses. As a suggestion, you can reduce your risk by setting up stops on your losses to protect your balance if the prices move against you.
- CFD trading comes with higher volatility for long-term traders. If you keep your CFD positions open for extended periods of time, this may boost the costs. In one such case, it would be better to buy the underlying assets.
- A broker may require CFD traders to pay for the spreads on entry and exit points. This significantly reduces the potential to realize profits from small investments. It is true that conventional markets are subject to extra fees and require more capital but the spread can also trim down your potential profits.
Platforms That Support CFD Trading
Many brokerages develop their trading software in-house, which may be considered a setback by prospective customers who are not accustomed to working with a proprietary platform.
One viable course of action in this case would be to open a demonstration account with the respective broker and practice with a free balance until you get a proper feel of how everything works.
With that said, the majority of brokers still prefer to use third-party platforms, developed by the Russian company MetaQuotes Software. Two versions are usually offered for a free download on Mac and Windows-based computers.
The more popular but older option is the MetaTrader 4 (MT4), which many brokerage clients still prefer to use. This one was created specifically for Forex traders.
If you are looking to trade with CFDs, we suggest you use the newer MetaTrader 5 (MT5) because it was built specifically for trading instruments like CFDs, futures, and stocks. Both versions are mobile compatible, with free apps available at the Google Play and the Apple stores.
There are tons of great features on either platform. Both boast user-friendly interface and offer different functionalities including many timeframes, one-click trading, multiple languages, tools for technical analysis, and automated trading. There is also a browser-based version, called WebTrader, which does not require additional software downloads.
Regulations Rundown – Who Can Trade CFDs?
One important thing to keep in mind if interested in CFD trading is the fact this instrument is not legal in all jurisdictions because of its high volatility. Many brokers who offer this service are required by their regulators to prominently display disclaimers on their websites, warning clients about the financial pitfalls associated with this derivative.
The regulatory requirements are country-specific. For example, under the rules enforced by the Financial Conduct Authority (FCA) in the UK, brokers are expected to carefully assess the suitability for CFD trading of each customer. Those who are not experienced or knowledgeable enough will be denied the service.
CFD trading is legal in Australia as well. However, the local financial watchdog, ASIC, labels this instrument as “detrimental” to retail customers. In August 2019, the Australian regulator went as far as to propose severe restrictions on leverage as well as on what markets locals can trade CFDs on.
On a previous occasion, ASIC drew parallels between casino gambling and contracts for difference, suggesting the former is less risky. This echoes the sentiments of American investor, philanthropist, and businessman Warren Buffett, who once described derivatives like the CFD as “a financial weapon for mass destruction”.
Trading on CFDs in Europe is regulated under the Markets in Financial Instruments Directive (MiFID). This piece of legislation enables brokers based in member states of the EU to offer speculative products to customers residing in all other countries of the Union.
Other territories where this derivative is legal include most of Europe, Canada, Japan, Singapore, the United Arab Emirates, and Cyprus. In some places like South Africa, the instrument is not officially declared illegal but is not regulated, either.
Maximum leverage requirements vary depending on local regulations. The United States, Belgium, and Brazil are some of the jurisdictions where CFD trading is completely outlawed.