What Is A Contract For Differences (CFD)?

Contract for differences (CFD) trading is a relatively high-risk investment strategy, comprising an agreement between the investor and the broker based on the performance of a derivative or financial instrument.

The basic concept is that, whatever the difference between the opening and closing valuation, the amount is settled, without any physical asset or security changing hands.

Note that CFD trading is not permitted everywhere. In the US, for example, CFDs are illegal because they are over-the-counter products that do not move through regulated exchanges and are therefore banned by the Securities and Exchange Commission and the Commodity Futures Trading Commission.

CFDs are, however, legal in the UK, provided they comply with the Financial Conduct Authority guidelines.

The Trading Concept Of CFDs

Traders use CFDs as an alternative to traditional investments, where they can gain from both rises and falls in financial markets.

Normally, an investor would buy a stock with the expectation that the value will rise unless they buy stocks intending to short them.

However, CFDs can work both ways:

  • Long trades mean that the investor pays their margin expecting the price to rise and to make a cash gain based on the increase in value.
  • Short trading infers that the trader is betting the price will fall, so they position their margin based on a decreased value. Then, the trader sells the opening position and waits to see whether their forecast is correct.

Although experienced traders with good market knowledge best deploy CFDs, they are one of the few opportunities to profit from financial market falls.

A trader who holds a CFD and sees the price of the underlying asset rise can offer their position for sale, with the difference between the sale value and original purchase price netted, to represent the gain or loss to be settled through the broker.

This works vice versa if the trader expects the security price to drop, placing an opening sell position. Then, to close that position, the trader buys an offsetting trade, with the same net difference calculated to determine the difference to be settled in cash.

Advantages Of CFD Trading

CFD trades are relatively simple to execute since the broker, rather than the investor, manages the bulk of the investment transaction. As a result, the trader has equal access to the risks and benefits of the security, although they do not need to own it or take any further action.

Brokers offer margin trades, which means the investor contributes a proportion of the trade value, borrowing to increase their position or the leverage to maximise their potential gains.

However, traders must have a minimum account balance or transaction history to borrow above a threshold or engage in CFD trades with high leverage.

Other advantages of CFDs include:

  • Access to more of the market, with a range of investments and asset classes, to increase portfolio diversification while avoiding potential barriers to entry.
  • Entering into CFDs with brokers who can facilitate an investment contract for a fraction of the cost of a single stock, where the asset is highly valued.
  • Options to short sell or long buy, possibly gaining regardless of whether the asset price rises or falls.

CFD brokers often allow higher leverage, with margin requirements ranging from two to 20 per cent. This means a smaller initial outlay and a higher possible return margin for the trader against their original investment.

While CFDs are banned in the US, where they are permitted, the restrictions are slightly less limited and usually have lower capital requirements than standard exchanges. Some brokers will agree to CFDs for account holders with as little as a £1,000 balance.

There are no overarching rules on short-selling, and traders can short an instrument whenever they wish, since they do not own the underlying asset and do not need to cover borrowing costs.

Brokers make a profit because the trader pays the margin, with the broker taking a spread on each CFD or asking price quoted.

Disadvantages Of CFD Trading

The most significant risk of CFDs is that the associated market risk is high, and there is a greater probability of losing out on a trade, particularly when market conditions are less favourable.

A CFD might be straightforward to execute, but it is a complex financial instrument with various obligations for CFD platforms and brokers to publish risk warnings that alert traders that over half of retail investors tend to lose money trading CFDs.

That figure varies with time but is usually above 50 per cent and can be as high as 80 per cent depending on trading figures on each brokerage site.

Beginner traders are ill-advised to try CFD trading or take any significant risks since the leverage available against CFDs can make much higher profits with a smaller spread but can multiply losses many times over.

Even if the outlay is small, there is still the potential to lose large amounts, plus needing to pay financing charges depending on the level of associated lending.

In some cases, borrowing fees can be higher than the CFD trades’ value.

CFD trades are rarely used as a long-term outlook because most contracts have a time limit when the gain or loss crystallises. Therefore, a CFD is better utilised as a short-term position against a movement you believe is fairly certain, without excessive risk exposure.

CFD Trading Regulations

Because CFDs are high risk, financial bodies and industry regulators impose multiple restrictions to limit trading. CFDs are legal in the UK, but brokers and exchanges must comply with several rules:

  • Leverage is limited on CFD trades to between 30:1 and 2:1.
  • Brokers must close a position on behalf of the trader when available funding drops to half the margin necessary to sustain an open position.
  • Trader accounts must have protection to ensure a CFD trade cannot lose more than the funds available.
  • Exchanges or brokers cannot offer incentives, whether monetary or non-financial. That precludes sign-up incentives or free trading access for CFD traders.
  • Every site offering CFD trades must publish a risk warning and notify traders how many retail investors have lost money through CFD trading.

Every UK firm must abide by these rules, and regulations can be stricter in other jurisdictions.

Learning CFD Trading

The safest way to learn about CFD trading is to use a demo account, where you set up your account like a trader but use virtual money to test the outcome of potential trades you might decide to pursue.

Investments and assets are real, but the trade isn’t made, which allows you to monitor how the value and prices change in real-time, without risk.

While CFDs can be a low-cost way to trade in assets you might not otherwise have had the capital to invest in, various trading strategies are used, and you should ensure you are confident in your skills and analyses before you put any funds at risk.

What Is A Contract For Differences FAQ

What are contracts for differences?

CFDs are financial contracts between a broker and an investor, where the return is the variance between the opening and closing values of the financial instrument.

The idea is that an investor can trade based on trends in securities as a short-term way to generate returns, commonly used in commodities and FX markets.

What is an example of a CFD?

In our illustration, we have £1,000 to invest. Rather than buying 100 £10 shares, we agree on a CFD with a broker, putting forward five per cent of the same trade – we contribute £50 towards the share purchase.

This initial stake is called our margin.

If the shares rise to £15, achieving a £500 profit on the £1,000 invested, we get £500 but don’t need to stake all of our investment value on the outcome. However, if the 100 shares fall to £5, we pay the £500 difference to the broker.

How risky are CFDs?

The inherent risk with a CFD is that, while you aren’t buying the asset itself, you are trading on an underlying asset, so if you make lots of bad calls, you could lose a significant amount very quickly.

However, you have a broad choice of investments, pay lower fees and have greater access to financial markets and asset classes than you otherwise might.

Can investors make money on CFD trading?

Yes, it is possible to make profits, although usually only if you have made educated trades based on research into whatever asset your CFD is leveraged against.

The risk of a loss is also much higher, and around half of retail investors lose money through CFDs, so it is essential to have thorough knowledge about the asset class in question.

Can I hold CFDs as a long-term asset?

Investors could potentially trade CFDs over the longer term by using a buy-and-hold approach, which is normally advisable if they expect the asset value to increase over a longer period – this is called position trading.

Below is a list of related articles you may find of interest.

Leave a Comment