CFDs are a unique financial instrument that stands for ‘Contract for Difference’ where settlement differences in futures contracts between counter-parties are made through cash rather than physical delivery of an asset. CFDs are provided by online brokers and enable investors to exchange the difference in a contract of a specific asset’s price movement within the entry and exit of the contract — without owning the underlying asset.
CFDs were originally only traded by banks and other financial institutions as a form of equity swaps used to speculate on markets and hedge risk. However, CFDs have been increasing in popularity among countries across the world, but notably, they are not available in the U.S.
Established rules on OTC products in the U.S. require CFDs to be traded by retail investors on regulated exchanges, but there are no regulated exchanges for retail investors that support CFD trading in the country.
The market for CFDs is not highly regulated, although CFDs have come under increasing regulation in Europe due to significant losses sustained by retail investors and the prevalent use of leverage with low margin requirements. Nonetheless, CFDs remain an immensely popular investment vehicle because of some inherent advantages they confer.
CFDs are also making headway into digital assets, with some exchanges and brokers offering crypto CFDs side-by-side with conventional CFDs and other instruments.
How CFDs Work
CFDs are enormously popular on the London Stock Exchange, where their use in risk hedging accounts for a considerable portion of volume on the exchange. Brokers offer CFD products in markets around the world, making them highly accessible, and traders can leverage CFDs for numerous assets.
CFDs are technically derivatives, traded OTC through brokers rather than being listed on regulated exchanges like stocks and bonds.
CFDs can encompass assets such as:
CFDs are agreed upon between two counter-parties — an investor and a broker. The contract stipulates the payment (in cash) of one party to the other based on the difference in the price movement of the underlying asset from entry to exit of the contract. Notably, there is no contract expiration date like with conventional futures contracts, and the participants do not own the underlying asset. Rather, they are speculating solely on the price movement, and the contract can remain open — rolling into the next day’s trading — as long as the investor’s account margin value can support the contract.
Investors can exit their contract position with a broker without paying specific fees because the broker pulls in revenue by making the investor pay the spread — the contract trade will actually show a loss equal to the spread at the time of transaction entry by the investor. When buying, the trader pays the ask price, and when selling, the sale is made on the bid price.
Similar to futures contracts, investors can take a long or short position with a CFD on the price movement of the underlying asset.
For example, if Alice enters into a CFD with Bob’s Brokerage on the price of Commodity A, and Alice is long on Commodity A, she will buy the ask price of $50.50 for Commodity A with Bob’s Brokerage. If Alice buys 100 units of Commodity A, the total cost of the transaction will be $5,050.
However, leverage minimums for CFDs are exceptionally low, so if Bob’s Brokerage offers 10 percent margin on Alice’s CFD, then Bob’s Brokerage will require only $505 in cash for Alice to support the position adequately. Since Alice’s entry was at the ask price, the price needs to cover the spread for her to breakeven. Any additional gains are paid to her at the time of exit as a profit.
So, if Commodity A surges to $51, then Alice will theoretically make a $50 profit. However, the requirement for Alice to exit at the bid price and larger spread with the CFD will make the profit slightly less than $50, depending on the circumstance. Therefore, Alice has made close to a $50 profit on a $505 investment — an ROI of roughly 10 percent. In the end, Alice gets to keep more money because she is not paying commission fees.
The reverse situation works if Alice wants to short the position, but instead, the close price is subtracted from the open price to calculate the profit per unit.
CFDs are so popular because of their broad access, better returns on fruitful speculation, low investment minimums, and high leverage opportunities. However, they also come with some disadvantages and their low margin requirements can quickly lead to substantial losses by retail traders if a contract turns sour.
Read: What is Forex Trading?
We have covered quite a few CFD Brokers here on DemandSolutionNews, these brokers are open to retail traders or professionals and offer a wide range of trading instruments such as Forex, Cryptocurrencies, Commodities, Shares and so on.
- IQ Option
- Vantage FX
- ETX Capital
- City Index
Advantages of CFDs
Overall, CFDs are broadly accessible for a range of financial assets and have unique advantages drawing from their differences from futures and options markets. In particular, CFD trading is cheaper than trading real assets, enables higher leverage, has global access, and is not subject to shorting restrictions.
CFD trading is cheaper than trading real assets for several reasons. First, investors save 0.5 percent on transaction costs because since they do not own the underlying asset, they are not subject to the buy Stamp Duty. Second, investors do not pay commission fees because they are entering the CFD contract at the ask price and the broker is earning revenue through the spread — fixed spreads are also usually available. Third, execution of professional trading on stock exchanges of contingency trades can come with a fee — with CFDs, it does not. Finally, investors can easily tap a CFD market by initiating a margin account for future trading through a broker.
One of the major boons of CFDs is its low margin requirements. Sometimes reaching as little as 3 percent, retail investors can make more substantial returns with smaller down payments. For instance, at a margin rate of 5 percent, Alice only has to pay $500 to enter a $10,000 contract. However, such leverage comes with higher risks if the contract turns bad for the investor and can expose them to considerable losses, which has become a point of contention among regulators with CFDs.
The global accessibility of CFDs is also an important benefit they confer. Investors can access everything from blue-chip stocks to commodities via price speculation and CFDs are a trivial way for less experienced investors to enter the market. Many international markets are hard to access, and traders can speculate on price movements on various assets on a single platform through a broker.
Finally, CFDs are not subject to shorting rules is specific markets like borrowing requirements of the underlying asset and the additional broker fees associated with short selling calls.
One of the primary areas that larger investors employ CFDs is for hedging risk in volatile markets, as well as diversifying portfolios — a convenience due to their quick accessibility and range of assets covered.
Disadvantages of CFDs
Increasing regulatory scrutiny of CFDs primarily stems from the sizeable losses and risk that retail traders are exposing themselves to with low margin requirements. Adverse price movements with high leverage can rapidly wipe out a trader’s investment. The prevalence of CFDs among more inexperienced traders draws from their accessibility and ease of use, which compounds the problem of novice traders exposing themselves to excessive risk.
Although regulatory oversight is growing and actually welcomed by many participants in the CFD ecosystem, CFD brokers are not as tightly regulated as with other financial instruments. The credibility of brokers mostly favors reputation rather than government oversight or liquidity. As such, it is imperative for investors to research the best broker for their CFD trading prudently.
The requirement of traders to pay the spreads also makes CFDs inconvenient for most small trades. Additionally, the overnight holding of a CFD contract incurs fees, which makes them costly for long-term holding positions.
CFDs are a unique contract on the price of an underlying asset between counter-parties that have gained considerable mainstream favor over the last decade. Their accessible nature and vast margin opportunities are appealing to many retail investors around the world. Several brokers already offer CFDs on cryptocurrencies like Bitcoin and Ethereum, and that trend is likely to continue snowballing as 2019 unfolds.