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Contracts for difference (CFDs) have become an increasingly popular derivative financial instrument for speculation among retail traders, and they can now be traded on a wide range of underlying assets. CFDs allow traders to speculate on the price movements of an underlying asset without actually owning that asset.
A compelling reason for getting into CFD trading versus trading the underlying asset is that the trader can use leverage. This means that CFD traders can control larger positions with a smaller amount of capital.
Also, since CFD traders have no actual position in the underlying asset when trading CFDs, they do not have to worry about going through the often-cumbersome delivery process of an asset. Benzinga explains in the following article what CFDs are, how trading them works and how to find an online CFD broker so you can trade them in your own account. If you currently trade forex or stocks, or if you just want to learn more about CFDs, then read on.
How Does CFD Trading Work?
CFDs are derivative contracts, which means that instead of trading a certain asset, currency pair or futures contract in your account, you’re buying or selling a contract on the differential of a price to be liquidated at a later time.
When you enter into a CFD trade, you enter into an agreement with the CFD provider to exchange the difference between the price of an asset or an exchange rate, not the asset itself, observed at both the onset and liquidation of the trade.
The CFD buyer agrees to pay the seller the difference between the current price of the underlying asset and its price at the time the contract is closed. If the difference is positive, the seller pays the buyer, and if it is negative, the buyer pays the seller.
CFDs can be used for taking long and short positions, which means that traders can profit from rising and falling markets. They also do not have to worry about uptick rules when shorting a stock asset. CFDs can be traded on a wide range of underlying assets, including stocks, indices, commodities and currency pairs.
CFDs are generally traded on margin using leverage, which means that traders only need to put up a small percentage of the total value of the trade to open and control a position. This aspect of CFD trading can magnify a trader’s potential profits, but it also increases their risk of losses.
While CFDs are now widely used as a speculative vehicle among traders, they are not suitable for most investors since they carry a high level of risk and can result in losses that exceed the initial capital invested. It is important to have a solid understanding of the underlying assets and the risks involved before trading CFDs.
CFD trading is not currently available to retail traders residing in the United States, although trading CFDs on listed and over-the-counter markets is permitted in major countries that include Germany, France, the U.K., South Africa, Thailand, Italy, Sweden, Belgium, Switzerland, Denmark, the Netherlands, Mexico and Norway. Special CFD trading restrictions may apply to residents of Australia, New Zealand, Hong Kong, Singapore, Canada, Japan, Spain and Israel.
Benefits of CFD Contracts
The benefits of trading CFD contracts over trading in their underlying assets are many. The most obvious is the fact that the trader does not need to take delivery or provide a buyer with the asset traded. The information below highlights many of the other advantages CFD trading has over trading in their corresponding underlying assets.
Wide Range of Assets and Flexibility
In today’s global marketplace, you can find CFDs trading on virtually every major index, commodity, stock and forex exchange. You can also trade CFDs on entire industry sectors such as the oil and gas sector and the banking and technology sectors, for example. You can find the most common CFDs available for retail trading listed below.
Common Types of CFDs
- Stock CFD: CFDs on corporate stocks are popular among retail traders. Available CFDs include those on the stocks of the largest and best-capitalized companies in the world such as Tesla Inc. (NASDAQ: TSLA), Apple Inc. (AAPL) and Alphabet, the parent company of Google (NASDAQ: GOOG). The price of these CFDs typically matches the market price of the listed stock, and CFDs let you leverage positions in the largest and most liquid stocks. Remember that no physical shares are exchanged or dividends paid, and when trading a CFD contract on shares, you are only speculating on whether the underlying stock’s price will go up or down.
- Forex CFD: Forex CFDs can be used as an alternative to trading in the spot or futures market. They are usually commission-free and feature tight dealing spreads in the major currency pairs like EUR/USD, GBP/USD and USD/JPY. Exchange rates for CFDs mirror the spot cash market and forex CFDs do not go to delivery but are instead liquidated by cash settlement or by offsetting the position in the forex CFD market.
- Commodity CFD: You can trade a wide range of CFDs on commodities including energies, metals, agricultural products, livestock and meat.
- Index CFD: Instead of trading futures contracts or options on indices, you can trade the equivalent index CFD for a lower margin amount. Available CFDs include those on the S&P 500 Index, the Dow 30, NASDAQ 100 and a slew of international indices such as the French CAC40, the U.K. FTSE 100, Germany’s DAX index and Japan’s Nikkei 225.
Depending on where you’re based, CFD brokers offer different leverage ratios for CFD types. Many stock CFD brokers also charge a per-share fee as well as a percentage of the transaction, while most commodity and forex CFD brokers typically charge no commission and rely instead on the dealing spread to make their money. Be sure to check with your current or prospective broker for information on its CFD commission and fee schedule.
The Opportunity to Leverage
Trading CFDs gives you the opportunity to use leverage. Leverage increases your profit potential but also increases your exposure to adverse market moves. Standard leverage ratios in the CFD market are subject to regulation. The CFD leverage ratio available to you can depend on your jurisdiction and the regulatory body that oversees the CFD market in your area.
When you leverage your CFD positions, the CFD provider is lending you the funds to cover your entire position. You must put up an amount of money known as margin that serves as the collateral for the money you need to establish a CFD position. If you wish to hold the CFD trade over a longer period of time, you may also be required to put up what is known as maintenance margin.
When the funds in your account drop below a certain level from a losing trading position, you may receive a margin call. If this happens, it means that you must either put up more money to continue to hold the position or liquidate the position immediately.
You may also have the option of reducing the size of your position to meet the margin call. Make sure you check with your broker since some brokers will automatically liquidate your positions immediately if you get into a losing situation that would otherwise incur a margin call.
While leveraging CFD positions can increase your profits considerably, your overall risk increases by the same amount. Placing stop-loss orders and using prudent money management techniques can help reduce your risk when using leverage.
Benefit from Both Positions
Trading share CFDs means you can go long or short without needing to borrow stock or adhere to any other rules that apply to selling stocks short, like an uptick rule for example. Since trading CFDs means you’re trading contracts and no underlying assets trade hands or go to delivery, you can go long or short at any time. Going long or short a CFD contract is possible as long as you have met the margin requirements by having sufficient funding in your trading account.
Hedging Your Portfolio
In addition to using CFDs for speculation, you can also use them to hedge an existing portfolio. For example, if your stock portfolio contains mainly quality stocks, you can short a relevant index CFD if you think the overall stock market might decline. Likewise, with forex, you can position yourself in the opposite direction to your current currency futures or spot position by transacting an equivalent and offsetting amount of currency pair CFDs.
Risks of CFD Contracts
You will find risk any time you trade in financial or commodity markets, although trading some CFD contracts can be riskier than others. The volatility of the underlying asset plays an important role in the risk profile of any given CFD, so make sure you do your due diligence and research on the underlying market before trading a CFD on it.
Risk of Substantial Market Losses
Although you may leverage more and incur lower costs using CFDs, if you trade in volatile underlying assets, you may put your entire account at risk with one sharp adverse move. Also, when markets see increased volatility, dealing spreads can widen. This situation can lead to less profitable CFD trades for those using short-term trading strategies.
An extraordinary market event, such as the outbreak of war, a stock market crash or a change in a currency peg like the Swiss Shock in January 2015, can and has put entire brokerage firms out of business.
Make sure you remain aware of and can manage all the risks involved before you start trading CFDs and avoid trading with money you cannot afford to lose because you need it for mortgage payments, food and other living expenses.
Risk of Liquidation
If your CFD positions go against you, your account could be liquidated immediately and without prior notice by your CFD provider. While you may get an advance warning in the form of a margin call from some providers, most CFD providers just offset your losing positions as soon as a certain amount of money has been lost from your trading account. Check with your broker to find out what its liquidation policy is for losing positions.
Counterparty risk occurs when the other party to a transaction fails to meet their obligations and fails to deliver on the financial contract. All derivatives including CFD trades must have a counterparty to take the other side of the trade.
Often the CFD provider or another trader using the same broker act as the counterparty to CFD trades, so you will want to use a reputable and financially solvent CFD provider. Be aware that the CFD industry lacks the stringent regulation of other markets, so if a counterparty does not meet its obligation, you may find you have little legal recourse through a regulator.
Make sure you thoroughly research the CFD provider you plan to use before opening an account. CFD brokers rely on their reputation, past performance, longevity, financial position and credibility more than on their standing with a government regulatory agency, so make sure you use a reputable broker.
Contract for Differences Terminology
Market terminology for CFDs matches terminology used in other financial markets and typically has the same meaning. Here are some of the most common terms used in trading CFDs:
- Going short: If you believe the value of an asset, exchange rate or stock will decline, you would short the CFD. Going short means you sell a CFD to initiate a short position with the objective of buying or covering the short at a lower price. Your profit would be equal to the difference between the sell and buy prices.
- Going long: If you believe an asset, exchange rate or stock will increase in value, you would go long the corresponding CFD. The opposite of going short, going long refers to purchasing a CFD with the objective of selling it for a profit after the underlying instrument appreciates. Your profit would be equal to the difference between the buy and sell prices.
- Lot: A CFD lot is the minimum tradeable unit or quantity of the underlying asset. For example, a full forex lot would consist of 100,000 units of the base currency, while a round lot of stock would consist of 100 shares. Each underlying instrument’s CFD will have a lot size, and some brokers will allow you to trade in mini, micro and nano lots on some CFD types like forex currency pairs and gold and silver.
- Initial margin: Before you can begin trading CFDs, you must deposit an initial amount of cash into your trading account to use as margin. The initial margin for a particular CFD position is typically a percentage of the price of the asset or amount of currency to be traded. For example, a CFD on 1,000 shares of a $10 stock at a 20% margin rate would be $2,000 or 20% of 1,000 X $10 = $10,000.
- Maintenance Margin: To hold a CFD position overnight or for an extended period of time, CFD providers may ask for a maintenance margin in the event of unforeseen overnight moves. The maintenance margin rate varies depending on the performance of the CFD and the amount of money in the account.
Considerations for Contracts for Difference
When trading CFDs, you should be aware of some of the contract and pricing details that affect your trades. In addition to the underlying asset, you should take into consideration the following factors when trading CFDs.
The dealing spread is often the only charge you will pay for CFD execution with some brokers. Others may charge a commission or fee in addition to the dealing spread. If you enter the market to buy, you must buy on the offer or ask price, while if you want to sell, you must sell at the bid price.
Depending on the volatility of the underlying asset, the dealing spread may be narrow, which can present short-term traders with more profit opportunities, or it can be wide, which reduces short-term trader profits and helps protect the market makers.
Whether CFD providers widen or narrow their dealing spreads depends in large part on the volatility of the underlying asset. The higher the volatility, the more inherent risk is taken by the dealer, so the resulting dealing spreads are wider.
The duration of CFDs depends on the underlying asset. Most CFDs have an indefinite duration, but some CFDs are on futures contracts that have a monthly expiration, typically in the second or third week of the month. CFD providers often provide their clients with a rollover option with these types of contracts.
Such CFDs automatically expire on the same timetable as the corresponding futures contracts and settle for a cash difference if in the money. Check with your CFD provider for more details on the duration of any CFD you are interested in trading.
The size of the deal when trading CFD is important since a percentage of the value of the transaction is required for a margin deposit. Deal sizes consist of units of the underlying asset you plan on trading. For example, if you plan on buying a CFD with a deal size of 100,000 shares of stock, then you would need to deposit a percentage of the value of the shares to initiate the trade in your margin account.
Profit and Loss
The profit and loss on a CFD position consist of the difference between the entry and exit prices or exchange rates multiped by the total size of the contracts traded.
Costs of CFD Trading
CFD trading has some extra costs associated with it that you should be aware of. Some of these costs are routinely charged by all CFD providers, while other fees may not apply to your situation. Accordingly, make sure to check with a potential CFD broker what its applicable CFD trading costs will be in your specific case before opening an account with them.
The dealing spread is how CFD providers make their money, and it equals the difference between the bid and offer prices of an asset. The dealing spread can vary depending on the asset being traded and current market conditions.
If a forex CFD position is held overnight, the trader may be charged or paid a funding fee. The fee is based on the interest rate differential between the two currencies in the trade.
When each trading day closes at 5 p.m. New York time, the CFD positions in your trading account might be charged a holding cost. This fee can be added or deducted from your balance depending on the direction of your CFD trade and the relevant holding rate. Some CFD providers post holding rates expressed as an annual percentage rate (APR) on their websites for each asset.
Some CFD providers charge a commission for each trade. The commission is usually a percentage of the trade value. Also, while most CFD brokers do not charge commissions on forex or commodity trades, they might charge a commission for stock CFD trades.
Market data fees
Market data fees are charged by some trading platforms for users to trade or view pricing data for certain assets.
Example of CFD Trades
CFD trades in stocks or commodities can have some significant differences compared to trading the underlying asset, although they tend to be similar for currency pairs. Two examples of CFD traders are detailed below, although they do not include commissions, fees or holding costs that the trader may incur since those charges are specific to particular markets and CFD providers.
Example 1: Going long
Consider the situation where a trader wants to buy a CFD in 1 lot or 100,000 euros on the EUR/USD currency pair. The current market for EUR/USD is 1.1000/03, so the trader buys a CFD on 100,000 euros at 1.0503. If the market bid rate then rises to 1.1033, they can sell out the CFD for 30 pips profit. On 100,000 euros, 30 pips are worth $300. The trader paid away the dealing spread to enter and exit this CFD position, but they did not have to pay any commission or overnight fees.
Example 2: Going short
Consider the situation where a trader wants to sell a CFD in 10 lots or 1 million pounds sterling on the GBP/USD currency pair. The current market for GBP/USD is 1.2500/05, so the trader sells a CFD on 1,000,000 pounds at the bid side of 1.2500. If the market offer rate then falls to 1.2450, they can buy back the CFD for 50 pips profit. On 1 million pounds, 50 pips are worth $5,000. Again, the trader paid away the dealing spread to enter and exit this CFD position, but no commission or overnight fees were charged to them.
Can You Trade CFDs using any Online Broker?
Not all online brokers offer trading in CFDs, although many now do. Also, you may not be able to trade CFDs from your residential jurisdiction due to local laws.
You will need to review the CFD asset classes offered by a particular broker closely before opening an account with them to make sure they offer the specific CFDs you wish to trade. You should also confirm if trading CFDs is available to you in your present location.
Are CFDs Right for You?
CFDs can be a high-risk, high-reward financial instrument that requires knowledge, experience, and a high tolerance for risk. Whether CFDs are right for you will therefore depend on your trading goals, experience level, risk tolerance, available capital, trading experience and available time. It's therefore important to do your research and understand the risks involved before trading CFDs.
Trading CFDs may be a suitable option for you if you are comfortable taking on substantial market risks that can include the loss of your trading capital. If you plan on using the leverage that CFD trading offers, you should also have experience trading in volatile markets and have sufficient capital to cover any losses you might incur. Conservative investors and those new to trading may want to consider other less risky investment options.
CFDs can be used to speculate on short-term price movements in the financial markets or as a hedging tool to manage risk in a portfolio. If your trading or investment goals align with these strategies, then CFDs may be a suitable option for you.
Finally, trading a CFD generally requires monitoring the underlying market and staying up to date with economic and political events that can impact that market. This can require a significant time commitment to monitor the market adequately and make informed trading decisions.
Compare CFD Brokers
If you have decided that you want to get involved with CFD trading, then Benzinga has taken some of the guesswork out of finding a suitable broker by creating the following comparison table you can use to find the best CFD broker and platform that meets your trading needs.
- securely through Forex.com NON US's websiteBest For:Forex Trading in and Outside the U.S.
CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 68% of retail investor accounts lose money when trading CFDs with this provider. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.
- securely through eToro Forex's websiteBest For:Demo Accounts
CFD trading is not available to U.S. users. 76% of retail investor accounts lose money when trading CFDs with this provider. You should consider whether you can afford to take the high risk of losing your money.
Frequently Asked Questions
What happens when you buy shares of CFDs?
When you buy shares of CFDs, you are entering into a contract with a CFD provider to trade the underlying asset without actually owning it. When you close the position, the CFD provider calculates the difference between the opening price and the closing price and then pays you the profit or charges you the loss.
Why are CFDs banned in the United States?
CFDs are banned in the United States due to their high risk, lack of transparency and regulation, and the risk of a conflict of interest arising between a trader and their CFD provider. The US regulatory authorities have strict rules to protect retail investors from high-risk financial instruments, and they have deemed CFDs unsuitable for the US market.
How long can you hold CFDs?
CFDs are flexible financial instruments that can be held for various timeframes, ranging from minutes to months or even years. The length of time you might want to hold a CFD depends on several factors, including the terms of your contract with your CFD provider and your trading strategy. CFD providers often charge overnight financing fees for positions held open past a certain time, such as 5 pm New York time. These fees can be either positive or negative depending on the direction of your position.
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