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What are CFDs?

CFDs Definition

CFDs, also known as Contracts for Difference, are agreements between two parties to exchange the difference in the value of an underlying asset, from when a trade is opened to when it is closed. CFDs are a form of derivative contract allowing investors to trade forex, cryptocurrencies, commodities, indices, and individual stocks. Think of a CFD as a bet between a trader and broker on whether the price of a security will go up or down.

Learn what CFDs are, the advantages and disadvantages of CFDs, and how best to use them.

Table of Contents

CFDs Explained with Examples

A CFD (contract for difference) is a type of derivative, a group of investments that derive, in part, their value from an underlying asset. [1] While derivatives can appear complex, their premise is quite simple, as they 'allow users to pass on an unwanted risk to another party and assume a different risk, or pay cash, in exchange.' [2]

A CFD is an agreement between a broker and trader which results in a profit or loss from fluctuations in the price of a security. Unlike forward or futures contracts, there is no fixed settlement date, allowing the CFD to be closed at a more favourable price for the trader. It is important to remember that a CFD is not an asset in its own right, unlike options. Instead, they work based on the changing price of the underlying security.

CFDs and futures contracts are popular instruments within the global market. According to Etoro, 92% of the world's 500 largest corporations use these financial instruments to manage risk. [3] However, according to Bloomberg Intelligence, retail investors have grown to account for 24% of the overall market share of US equity trading volumes in 2021. This growth has fuelled an increase in options and CFD trading. [4]

CFDs enable traders to trade on margin, which acts as a deposit to brokers. Traders can trade with leverage, meaning the broker lends capital to the trader, allowing them to deal with more capital, increasing their exposure. As a result, gains and losses are magnified for both traders and brokers.

In 2017, foreign exchange markets transacted around $5.4 trillion every day, with small to medium-sized firms offering CFDs to trade $1 billion per day due to increased exposure from leveraged trading. [5] Learning about position size calculators and setting up stop losses mitigates the potential risks of trading with leverage.

For example, if a forex trader believed, based on analysis of chart patterns, currency strength meters, and other metrics, that British pound sterling (GBP) could potentially rise against the Canadian Dollar (CAD), they could trade in CFDs:

In this example, a forex trader opens a 1 lot (100,000 units) long trade on GBP/CAD at an exchange rate of 1.7460. The CFD broker offers the investor 100 to 1 leverage, meaning they only need to provide 1% collateral of the position they wish to open. In this case, to open a 100,000 unit position, they only need to ‘put down’ 1,000 USD of their total 10,000 USD available in their account.

After some time, the investor closes the trade when the exchange rises by 1.546%, leaving them with a profit of 2,148.94 USD (a 21.5% increase on their 10,000 USD account). A prime example of CFD trading on margin, being used to monetise currency exchange rate volatility.

The margin rate is determined by the volatility of the underlying security price and the risk involved for the trader (depending upon the amount of leverage used). As this example shows, high leveraged CFD trading is a profitable instrument to utilise for experienced traders; however, given the potential volatility of markets and the increased exposure of high leveraged positions, it is crucial to be well informed before investing.

According to Finder, between 62% and 78.6% of retail investor accounts lose money when trading CFDs. [6] Given the associated risks, regulators have strictly monitored retailer's ability to CFD trade. The Financial Conduct Authority recently implemented new policies which limited leverage to between 30:1 and 2:1 and stopped retail traders from losing more money than the total of the funds in their trading account. [7]

CFD Trade vs. Share Trade

CFDs offer a higher potential opportunity to stretch and investors money further, or alternatively, destroy it quicker. To illustrate this, let’s compare a bullish investor capitalising on a positive share price move in Tesla Inc using a CFD position with 5:1 versus a traditional share trade with no leverage

This example highlights the advantage of using CFDs in a calculated and strategic way. However, using the same example with Tesla, if hypothetically the share price had decreased, rather than increased, the investor would have drastically larger losses on his CFD position.

By increasing trade exposure through leverage, CFDs are a valuable tool for traders to profit from the rise and drop in prices of underlying assets. It is crucial to learn more about why 90% of forex traders lose 90% of their equity in 90 days. Understanding how CFDs work, the margin rates, leverage amounts, and potential profits and losses are critical for any successful trader utilising CFDs.

Advantages and Disadvantages of CFDs

CFDs provide vast opportunities for companies to hedge risk, investors to speculate and policymakers to adjust their economy. With all that, comes a hefty cost -- after all CFDs have no intrinsic value, and are usually traded on borrowed money.

Advantages Explained

  • Smaller initial investment: Traders looking to use CFDs to trade do not need to make large deposits into their trading accounts. Trading with leverage allows CFD traders to use a smaller initial investment to trade.

  • Potential for large profits: As leverage increases traders' exposure to the volatility of markets, it presents the opportunity to gain exponentially more significant profits if their CFDs increase or decrease in price (depending upon their positions).

  • Wide range of markets: By investing in CFDs, traders have access to an extensive range of financial markets, namely, forex, shares, indices, commodities, ETFs, cryptocurrencies, and bonds.

  • Tax efficiency: Within the UK, profits from CFD trading are exempt from paying stamp duty. This gives investors a slight tax advantage.

Disadvantages Explained

  • Risk: Due to more considerable exposure and position, CFD trades are more vulnerable to volatile markets, price swings, and unexpected news.

  • Larger losses: while the upside for CFD traders of leveraged positions is that the profits can be more significant, the inverse is also true. The increased exposure can significantly increase losses if the CFD trade is unsuccessful.

  • It is difficult for inexperienced traders and investors: CFD trading is risky and volatile; as such, it can be difficult for inexperienced traders significantly if losses increase exponentially over short time frames.

  • Don't receive interest or dividend pay-outs on the asset: Unlike owning an underlying asset like a stock, CFD owners do not receive dividend payments or interest on their holdings.

What It Means for Retail Investors

CFDs, if used correctly, are an invaluable financial tool for investors. However, given the increased exposure and risk associated with leveraged traders, only experienced investors must trade with CFDs. For individuals new to investing and interested in the financial markets and CFD trading, read more about trading in the UK, forex courses, and how to undertake technical analysis is vital to trade profitably, safely, and successfully.

Article Sources

  1. U.S. Securities and Exchange Commission, "Derivatives," Accessed July 28, 2021.

  2. Federal Reserve Bank of St Louis, "Demystifying Derivatives." Accessed July 28, 2021.

  3. Etoro, "Understanding Contract for Difference (CFD)." Accessed July 28, 2021.

  4. Financial Times, "Rise of the retail army: the amateur traders transforming markets." Accessed July 28, 2021

  5. TRAction Fintech, “Comparison of Regulators & Rules for CFDs & Forex.” Accessed July 28, 2021

  6. Finder, "What are the risks of CFD trading?" Accessed July 28, 2021

  7. Financial Conduct Authority, "Restricting contract for difference products sold to retail clients." Page 5, Accessed July 28, 2021.

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