Unless you’re knowledgeable in derivative trading and finances, it is unlikely you have ever heard of ‘CFD’. It is a common component in this field that is on the same level of intricacy as blockchain technology. It is as beneficial as it is noteworthy, and it carries the same amount of popularity as many other innovations.
This article will go more into detail about what it is (starting with what it stands for) and how it works. Moreover, it will highlight a bit of history and explain the advantages and disadvantages of trading with it.
What does it mean?
‘CFD’ is an acronym for ‘contract for difference’. It is among the most popular forms of derivative trading. CFD trading allows you to hypothesize the increasing or decreasing prices of fast-moving global financial markets or instruments. These include shares, commodities, indices, currencies, and treasuries. A CFD offers European traders and investors the chance to profit from price movement. Moreover, they can do so without ever actually owning the underlying asset.
It is a contract between two distinct parties: the “buyer” and the “seller.” It stipulates that the seller will pay the difference between an asset’s current value and its value at contract time to the buyer. Should the difference end up being negative, then the buyer will instead pay to the seller.
It is pretty basic security whose calculation derives from the asset’s movement between trade entry and exit. Furthermore, computing only the change in price without taking the asset’s underlying value into consideration. This is by way of a contract between client and broker. On top of that, it doesn’t utilize any stock, forex, commodity, or futures exchange.
On the whole, trading CFDs offers an array of advantages (which we will go over later) that effectively increase the instruments’ enormous popularity. In the past decade, it has seen great success.
Trades in retail
In the late 1990s, CFDs were presented to retail traders. They were already popular thanks to several UK companies. They were innovative online trading platforms making it easier to see live prices and also trade in real-time. The first company to execute this was GNI (originally Gerrard & National Intercommodities). MF Global would later acquire GNI and its CFD trading service, GNI Touch. Following them were IG Markets and CMC Markets, with each starting to popularize the service in the year 2000.
Around 2001, several CFD providers came to the realization that CFDs had a similar economic effect as financial spread betting in the UK. In contrast, spread betting profits were free from Capital Gains Tax. Many CFD providers would launch financial spread betting operations, paralleling their CFD offering. In the UK, the CFD market reflects the financial spread betting market. What’s more, the products share countless similarities.
CFDs are exported to a number of different countries. Conversely, spread betting – in view of the fact that it depends on a country-specific tax advantage – remains a UK and Irish phenomenon.
CFD providers were beginning to extend to overseas markets. The start of this was with Australia in July 2002 by IG Markets and CMC Markets. Since then, a number of other countries have been acquainted with CFDs. They are available in a wide variety of locations. These include Australia, Canada, Hong Kong, Ireland, Israel, Singapore, South Africa, the UK, New Zealand, and many others.
However, CFDs aren’t permitted in a handful of countries; for example, the US. This is due to various rules about over the counter products. CFDs are not tradable by retail investors unless on a registered exchange. Furthermore, there are no exchanges in the US that provide CFDs.
How it works
Let’s assume that a stock’s asking price is $25.26 and the trader purchases 100 shares. This means that the cost of the transaction is $2,526 along with commission and fees. This trade has to have at least $1,263 in free cash at a traditional broker in a 50% margin account. Meanwhile, a CFD broker previously required a 5% margin, or $126.30.
A CFD trade will present a loss that is equal to the size of the spread at the time of the transaction. With that in mind, if the spread is worth 5 cents, then the stock needs to gain 5 cents for the position. Doing so will allow it to reach the breakeven price. You will notice a 5-cent gain if you were the owner of the stock. However, you would have to pay a commission and acquire a larger capital outlay.
Should the stock rally to a bid price of $25.76 in a traditional broker account, it can be sold for a $50 gain. Alternatively, it’s a $50/$1263=3.95% profit. Though, when the national exchange reaches this price, the CFD bid price might be $25.74. The CFD profit will be lower due to the trader exiting at the bid price. Moreover, the spread is much larger than on the regular market.
In this case, the CFD trader earns roughly $48 or $48/$126.30=38% return on investment. Additionally, the CFD broker might require the trader to purchase at a higher initial price, like $25.28. Regardless, the earning of $46 to $48 on the CFD trade indicates a net profit. Concurrently, the $50 profit from possessing the stock outright doesn’t include commissions or other fees. Thus, it grants more money to the CFD trader.
Advantages to CFD Trading
There is an abundance of advantages that come from utilizing CFDs.
1 – A much higher leverage
CFDs provide leverage that’s comparatively higher than that of traditional trading. The conventional leverage in the CFD market is often subject to regulation. At one point, it was as low as a 2% margin (50:1 leverage). However, it now has a limit in a range of 3% (30:1 leverage). It could potentially go up to about 50% (2:1 leverage). Requirements of a lower margin equate to less capital outlay for the trader/investor. Additionally, it means much greater potential returns.
Be that as it may, an increase in leverage can also amplify losses.
2 – There is global market access from a singular platform
A majority of CFD brokers offer products in all of the world’s major markets. This effectively allows users to have frequent access.
3 – There are no shorting rules or borrowing stock
There are certain markets out there that have an array of rules and regulations. Some prohibit shorting, require that the trader borrow the instrument before selling short, or have various margin requirements for short and long positions alike. It is possible to short CFD instruments at any time without borrowing costs. This is due to the fact that the trader does not technically own the underlying asset.
4 – There is professional execution that does not have any fees
CFD brokers provide a plentiful amount of the same order types as traditional brokers. These typically include stops, limits, and conditional orders, such as “One Cancels the Other” and “If Done.” There are some brokers who offer sure-fire stops that charge a fee for the service. Alternatively, they regain costs in a different way.
Generally speaking, brokers make money whenever the trader pays the spread. There are many who do not charge commissions or fees of any kind. In order to buy, a trader has to pay the asking price. Conversely, if they want to sell/short, then the trader must pay the bid price. The overall size of this spread largely depends on the volatility of the underlying asset. It’s also important to note that fixed spreads are often available.
5 – There are requirements for day trading
There is a requirement for minimum amounts of capital to day trade in certain markets. Alternatively, place limits on the number of potential day trades within certain accounts. The CFD market is not inherently bound by these restrictions. On top of that, all account holders are able to day trade if they want to. It is entirely possible for someone to easily open an account for as little as $1,000. Although, $2,000 and $5,000 are both the more common minimum deposit requirements.
6 – There is a wide variety of opportunities in trading
At this point in time, brokers offer stock, index, treasury, currency, sector, and commodity CFDs. This way, speculators residing in diverse financial vehicles are able to trade CFDs as an alternative to exchanges.
Disadvantages to CFDs
Just like how there are plenty of advantages to using CFDs, so too are there a good number of disadvantages.
1 – The traders pay the spread
While CFDs provide traders with a strong alternative to traditional markets, they also present several potential drawbacks. For instance, they have to pay the spread on entries and exits. This will basically eliminate the chance of them profiting off of small moves.
What’s more, the spread also diminishes the amount of winning trades by a small amount. This is especially evident in comparison to the underlying security. Moreover, it will increase losses by a small amount. So, traditional markets will present fees, regulations, commissions, and higher capital requirements to the trader. However, CFDs actively severs traders’ profits by way of spread costs.
2 – There are weak industry regulations
Something important to note is that the CFD industry does not have high regulations. Furthermore, the credibility of the broker derives from reputation, longevity, and financial position. These qualities are in lieu of government standing or liquidity. There are many excellent CFD brokers, however, it’s crucial to look into a broker’s background prior to opening an account.
3 – There are plenty of risks
CFD trading is a fast-moving process and requires the utmost focus when it comes to monitoring. There are several liquidity risks and margins that you will need to preserve. If you are unable to cover reductions in values, then your provider may wind up closing your open position. Moreover, you will have to meet the loss, regardless of what subsequently happens concerning the underlying asset. Leverage risks introduce you to greater potential profits, but it also leaves you vulnerable to greater potential losses.
Stop-loss limits are indeed available from many CFD providers, though they can’t ensure your immunity from losses. This is especially the case if there is either a market closure or a sharp movement in price. The risks that come with execution may occur on account of lags happening in trades. It is for these reasons that they are forbidden and unavailable to residents in the US.
CFD trading allows you to effectively sell (short) an instrument if you’re of the belief that it will eventually fall in value. Moreover, it aims to profit from the speculated downward movement of price. If your prediction ends up being correct, you will be able to purchase the instrument back at a lower price. However, if you are incorrect and the value ends up increasing, then you will experience a loss. This loss can potentially surpass your deposits.
Hedging your physical portfolio
Let’s assume that you have already invested in a pre-existing portfolio consisting of physical shares with another broker. What’s more, you are of the belief they may end up losing some of their value following the short term. If this is the case, you are able to hedge your physical shares with the use of CFDs. By short selling the exact same shares as CFDs, you can aim to make a profit from the short-term downtrend. This could potentially counteract any type of loss from your existing portfolio.
In order to further explain this, we have to set up a hypothetical scenario.
Imagine that you’re holding $5,000 worth of physical a company’s shares in your portfolio. You are able to hold a short position or short sell the comparable value of the company with CFDs. Then, should the company’s share price drop in the underlying market, the value loss of your physical share portfolio could potentially be offset by the profit. Specifically, the profit that is made on your short selling CFD exchange.
Afterward, you can close out your CFD trade as a way to secure your profit as the short-term downtrend concludes. Furthermore, when the overall value of your physical shares begins to rise once more.
Forex and CFD
There are certain distinctions between CFD and Forex that make them separate entities. That isn’t to say that they are completely different. On the contrary, they do, in fact, share a handful of similarities. However, there are not enough to make them one and the same, let alone close concepts regarding likeness.
What makes them similar?
First and foremost, let’s cover the similarities. Both of these trading types typically involve a similar process in trade execution. Traders are able to easily enter or exit the market in a similar manner in both rising and falling markets.
CFD trades and Forex trades both experience their execution on the same platform, utilizing comparable charts and pricing techniques. In the case of both, the execution of trades is in the over-the-counter (OTC) market. This is run electronically and within an entire network of banks with no discernable physical location or central exchange.
An additional similarity between the two types of trading is that the only trading cost is the spread. This is different from other types of trading instruments that usually charge commissions and other finance fee variants.
The most prominent similarity between CFD trading and Forex trading is that the trader doesn’t technically own the underlying asset. For example, when someone purchases EURAUD, they are not actually buying Euros and selling Australian dollars. Rather, the trader is basically just speculating on what the exchange rate will be. Likewise, whenever a trader buys a CFD contract on the FTSE 100, the trader does not own the stocks in the FTSE index. Instead, the trader is speculating its underlying price.
In a number of ways, one can say that Forex is essentially a separate type of CFD.
What makes CFD trading different?
For as much as CFD and Forex resemble each other, there is a reason that they are two separate entities. Now that their similarities are recognized, we must look into what differentiates them from each other.
The main distinction between the two trading types is that CFD trading typically involves different types of contracts covering diverse market sets. These include indices, energy, and metals. On the other end of the spectrum, Forex provides pure currency trading. Whenever you conduct CFD trading, you have the option to select several contracts that vary in increment value and currency type. These largely depend on the country of origin of the underlying asset. Forex trading centers around trading one currency against another currency. Moreover, it always involves trading in uniform lot sizes.
An additional difference between CFD and Forex correlates with the factors that are prone to influence the different markets. CFD trading is mostly under the influence of specific factors. These include such things as supply and demand of a commodity or changes in trends in association with business sectors. Conversely, the main driving point of Forex trading is global events, like substantial employment shifts or international political alterations.