What Is a Contract for Differences (CFD)?
A contract for differences (CFD) is an agreement between a buyer and a seller that stipulates that the buyer must pay the seller the difference between the current value of an asset and its value at contract time.
A CFD is a type of derivatives trade. CFDs allow traders andinvestors to profitfrom price movement without owning the underlying assets. The CFD does not consider the asset’s underlying value, only the price changebetween the trade entry and exit.
CFDs are increasingly popular in over-the-counter exchanges around the world but they are not permitted in the U.S.
Key Takeaways
- A contract for differences (CFD) is an agreement between an investor and a CFD broker to exchange the difference in the value of a financial product between the time the contract opens and closes.
- A CFD investor never actually owns the underlying asset but instead receives revenue based on the price change of that asset.
- Some advantages of CFDs include access to the underlying asset at a lower cost than buying the asset outright, ease of execution, and the ability to go long or short.
- A disadvantage of CFDs is the immediate decrease of the investor’s initial position, which is reduced by the size of the spread upon entering the CFD.
- Other CFD risks include weak industry regulation, potential lack of liquidity, and the need to maintain an adequate margin.
How Contracts for Differences (CFDs) Work
A CFD is an agreement between an investor and a CFD broker to exchange the difference in the value of a financial product between the time the contract opens and closes. It is an advanced trading strategy that is used only by experienced traders.
No physical goods or securities are delivered in a CFD transaction. A CFD investor never owns the underlying asset but is paid based on the price change of that asset. For example, instead of buying or selling physical gold, a trader can simply speculate on whether the price of gold will go up or down.
Investors can use CFDs to make bets about whether or not the price of the underlying asset or security will rise or fall. Traders can bet on either upward or downward movements. If the trader who has purchased a CFD sees the asset’s price increase, they will offer their holding for sale.
The net difference between the purchase price and the sale price is determined. The net difference representing the gain from the trades is settled through the investor’s brokerage account.
If the trader believes that the asset’s value will decline, an opening sell position can be placed.To close the position, the trader must purchase an offsetting trade. Then, the net difference of the loss is settled through the trader's account.
Countries Where You Can Trade CFDs
CFDs are allowed in listed, over-the-counter (OTC) markets in many countries, including the United Kingdom, Australia, Germany, Switzerland, Singapore, Spain, France, South Africa, Canada, New Zealand, Sweden, Norway, Italy, Thailand, Belgium, Denmark, and the Netherlands, as well as the Hong Kong special administrative region.
The U.S. Securities and Exchange Commission (SEC) has restricted the trading of CFDs in the United States, but nonresidents can trade using them.
When equities markets worldwide tumbled in 2022, investor interest in CFD trading also declined. A downturn in Google searches related to CFDs reflected the lower levels of engagement with the trading strategy. Declines in trading revenue by brokerage firms that offer CFD trading also signaled this downswing.
The Costs of Trading CFDs
The costs of trading CFDs include a commission (in some cases), a financing cost (in certain situations), and the spread—the difference between the bid price (purchase price) and the offer price at the time you trade.
There is usually no commission for trading forex pairs and commodities. However, brokers typically charge a commission for stocks.
For example, broker CMC Markets, a U.K.-based financial services company, charges commissions that start from 0.10%, or $0.02 per share, for U.S.- and Canadian-listed shares. The opening and closing trades constitute two separate trades, meaning the trader is charged a commission for both trades.
A financing charge may apply if you take a long position. This is because overnight positions for a product are considered an investment, and the provider has lent the trader money to buy the asset. Traders are usually charged an interest charge for each day that they hold the position.
Example of a CFD Trade
Suppose a trader wants to buy CFDs for the share price of GlaxoSmithKline.The trader places a £10,000 trade. The current price of GlaxoSmithKline is £23.50. The trader expects that the share price will increase to £24.80 per share. The bid-offer spread therefore is 24.80–23.50.
The trader will pay a 0.1% commission on opening the position and another 0.1% when the position is closed.For a long position, the trader will be charged a financing charge overnight (normally the LIBOR interest rate plus 2.5%).
The trader buys 426 contracts at £23.50 per share, so the trading position is £10,011.
Suppose that the share price of GlaxoSmithKline increases to £24.80 in 16 days. The initial value of the trade is £10,011, but the final value is £10,564.80.
The trader’s profit (before charges and commission) is as follows:
£10,564.80 - £10,011 = £553.80
Since the commission is 0.1%, the trader pays £10 upon entering the position. Suppose that interest charges are 7.5%, which must be paid on each of the 16 days that the trader holds the position (426 × £23.50 × 0.075 ÷ 365 = £2.06. Since the position is open for 16 days, the total charge is 16 × £2.06 = £32.92.).
When the position is closed, the trader must pay another 0.01% commission fee of £10.
The trader’s net profit is equal to profits minus charges:
553.80 (profit) - 10 (commission) - 32.92 (interest) - 10 (commission) = £500.88 (net profit)
Advantages of CFDs
Higher Leverage
CFDs provide higher leverage than traditional trading. Standard leverage in the CFD market is subject to regulation. It once was as low as a 2% maintenance margin (50:1 leverage) but is now limited to a range of 3% (30:1 leverage) and could go up to 50% (2:1 leverage).
Lower margin requirements mean less capital outlay for the trader and greater potential returns; however, increased leverage can also magnify a trader’s losses.
Global Market Access from One Platform
ManyCFD brokers offer products in all of the world’s major markets, allowing around-the-clock access. Investors can trade CFDs on many foreign markets.
No Shorting Rules or Borrowing Stock
Certain markets have rules that prohibit shorting, require the trader to borrow the instrument before selling short,or have different margin requirements for short and long positions.
CFD instruments can be shorted at any timewithout borrowing costsbecause the trader doesn’t own the underlying asset.
Professional Execution With No Fees
CFD brokers offer many of the same order types as traditional brokers, including stops, limits, and contingent orders, such as“one cancels the other” and “if done.” Some brokers offering guaranteed stops will charge a fee for theservice or recoup costsin anotherway.
Brokers make money when the trader pays the spread. Occasionally, they charge commissions or fees.
To buy, a trader must pay the ask price, and to sell or short, the trader must pay the bid price. This spread may be small or large depending on the volatility of the underlying asset; fixed spreads are often available.
No Day Trading Requirements
Certain markets require minimum amounts of capital to day trade or place limits on the number of day trades that can be made within certain accounts. The CFD market is not bound by these restrictions. All account holderscan day trade if they wish.
Accounts can often be opened for as little as $1,000, although $2,000 and $5,000 arecommon minimum deposit requirements.
Variety of Trading Opportunities
Brokers currently offer stock, index, treasury, currency, sector, and commodity CFDs.This enables speculators interested in diversefinancial vehicles to trade CFDs as an alternative to exchanges.
Disadvantages of CFDs
Traders Paythe Spread
While CFDsoffer an attractive alternative to traditional markets, they also present potential pitfalls. For one, having to pay the spread on entries and exits eliminates the potential to profit from small moves.
The spread also decreases winning trades by a small amount compared to the underlying securityand will increase losses by a small amount.
So,while traditionalmarkets expose the trader to fees, regulations, commissions, and higher capital requirements, CFDstrimtraders’ profits through spread costs.
Weak Industry Regulation
The CFD industry is not highly regulated. A CFD broker’s credibilityis based on reputation, longevity, and financial position rather than government standing or liquidity.
There are excellent CFD brokers, but it’s important to investigate a broker’s background before opening an account.
Risks
CFD trading is fast-moving and requires close monitoring. As a result, traders should be aware of the significant risks when trading CFDs. There are liquidity risks and margins that you need to maintain; if you cannot cover reductions in values, then your provider may close your position, and you’ll have to meet the loss no matter what subsequently happens to the underlying asset.
Leverage risks expose you to greater potential profits but also greater potential losses. While stop-loss limits are available from many CFD providers, they can’t guarantee that you won’t suffer losses, especially if there’s a market closure or a sharp price movement.
Execution risks also may occur due to lags in trades.
Because the industry is not regulated and there are significant risks involved, CFDs are banned in the U.S. by the Securities and Exchange Commission (SEC).
What Is a Contract for Differences (CFDs)?
A contract for differences (CFD) is an agreement between a trader and a financial institutionin which the investor bets on the future value of anasset.The difference between the open and closing trade prices iscash-settled.
There is no physical delivery of goods or securities. The client and the broker exchange the difference in the initial price of the trade and its value when the trade is unwound or reversed.
How Do CFDs Work?
A contract for differences (CFD) allows traders to speculate on the future market movements of an underlying asset without actually owning or taking physical delivery of the underlying asset.
CFDs are available for a range of underlying assets, such as shares, commodities, and foreign exchange.
A CFD involves two trades. The first trade creates the open position, which is later closed out through a reverse trade with the CFD provider at a different price.
If the first trade is a buy or long position, the second trade (which closes the open position) is a sell. If the opening trade was a sell or short position, the closing trade is a buy.
The net profit of the trader is the price difference between the opening trade and the closing-out trade (less any commission or interest).
Why Are CFDs Illegal in the U.S.?
CFDs are largely unregulated. They are products offered over-the-counter (OTC) rather than through exchanges. This places them out of the reach of the Security & Exchange Commission, which regulates the U.S. markets.
The Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) prohibit residents and citizens of the U.S. from opening CFD accounts on domestic or foreign platforms.
Is Trading CFDs Safe?
Trading CFDsis risky, and their potential advantages can overshadow the associated counterparty risk, market risk, client money risk, and liquidity risk. CFD trading can also be risky as a result of other factors including poor industry regulation, a potential lack of liquidity, and the need to maintain an adequate margin due to potential leveraged losses.
Can You Make Money with CFDs?
Yes, it is possible to make money trading CFDs. However, trading CFDs is a risky business relative to other forms of trading. Most successful CFD traders are veteran traders with a wealth of experience.
The Bottom Line
Advantages to CFD trading include lower margin requirements, easy access to global markets, no shorting or day trading rules, and little or no fees. However, high leverage magnifies losses when they occur, and having to pay a spread to enter and exit positions can be costly when large price movements do not occur.Indeed, the European Securities and Markets Authority (ESMA) has placed restrictions on CFDs to protect retail investors.
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