CFDs, also known as Contracts for Difference, is a form of derivative trading that allows one to trade the financial contracts of the instruments and to speculate on the price movements, without the need to take ownership of the underlying assets. CFD trading is widely used in FX, commodities, indices and shares trading.
In this article, we shall comprehensively dissect this online trading vertical, the risks involved, and its advantages and disadvantages.
What is a CFD?
As the name suggests, CFDs are simply contractual arrangements where traders pay for the difference in the bid (buy) and offer (sell) price of the contract. It is a form of derivative, given that the CFDs mirror the price movements of the underlying assets.
There is no physical delivery of the actual underlying assets, where transactions are cash settled as traders are just trading paper contracts to book the profits and losses. Hence, CFD trading is widely considered as an inexpensive and convenient way to speculate the market.
How do CFDs work?
To better explain the workings and characteristics of CFDs, there are four concepts to break down.
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Spreads and Commissions
Brokers earn from traders purchasing CFDs in two ways: Spreads and commissions.
CFD prices are usually quoted as two prices, namely: bid (buy) price and offer (sell) price. A Bid is the price chosen by a buyer to buy a CFD (opening a long CFD position), while the Offer is the price at which the seller is offering to sell the contract (opening a short CFD ).
In practice, sell prices are always slightly lower than the current market price, while buy prices are typically slightly higher. The difference between the two prices is commonly referred to as the spread.
In most instances, the cost to open a CFD position is usually covered in the spread, where buy and sell prices will be adjusted to reflect the cost of making a particular trade.
Besides spreads, brokers can choose to charge commissions as well, which is the fee paid by traders to the platform to help place a trade order to the market.
More often than not, brokers earn by either marking up a spread in their bid/offer prices with zero commissions, or offer raw spreads (zero mark up in spread) and charge a small commission for facilitating the buy/sell transaction.
For new traders, this might be perplexing to comprehend at the beginning but essentially, you will need to factor in the cost of trading, either via fees or commissions, and understand that different platforms will charge fees in different ways to entice traders to trade on their platform.
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Deal size
Another characteristic of CFDs is that they are traded in standardised contracts (also known as lots). The size of an individual contract is variable depending on the underlying asset being traded, often imitating how that asset is traded on the financial market.
For example, if silver is traded on commodity exchanges in lots of 5000 troy ounces, this means that its equivalent CFD will also have a value of 5000 troy ounces. With regards to share CFDs, the contract size is typically representative of one share in the company one is trading.
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Profit and Loss
Profit and loss calculation is the same as buying ordinary shares. One has to multiply the position size (total number of contracts) with the difference in price (in terms of pips or ticks). For example, if you are long 100 CFDs of Facebook and the price of Facebook increased by $4, you would have earned 100 x $4= $400. Similarly, if you were long on Facebook but the price of Facebook dropped by $2, you would have lost 100 x $2= $200.
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Duration
For the most part, most CFD trades have no fixed expiry date. How you can close a trade is by placing an order in the opposite direction to the one opened. For example, a buy position of 500 silver contracts would be closed by selling 500 silver contracts.
Furthermore, if a trader keeps a daily CFD position open past the daily cut-off time (which may vary for international markets), they will be charged an overnight funding charge.
However, this isn’t always the case, with the key exception being a forward contract. Forward contracts have an expiry date at some point in the future and have all overnight funding charges already included in the spread.
What are the advantages of trading CFDs?
The four most considerable advantages of CFDs are:
- Access to an underlying asset at a lower cost
- Ease of execution
- The flexibility to go long (buying an asset) or short (selling an asset).
- CFDs deliver traders all of the benefits and risks of owning an asset or security without actually owning it or taking any physical delivery of it.
CFDs are mainly traded on margin, which means that brokers allow traders and investors to leverage (i.e. borrow money) to enhance the size of their positions to amplify gains. The reverse holds true as well that leverage will magnify your losses. Brokers will typically require traders to maintain specific account balances before allowing this type of transaction.
CFDs usually provide higher leverage than traditional trading, with margin requirements ranging from as low as 2% to 20%, allowing traders to incur lower capital outlay and enjoy greater potential returns. Retail traders can often open an account with as little as $1,000 for CFD trading on brokerage platforms.
Given CFDs allow traders to incur minimal cash outlay to achieve their intended coverage, CFD is widely regarded as an extremely cash efficient instrument.
For example, assuming a fund manager wishes to construct an equity portfolio of the top 500 companies in the world, and instead of buying and selling the individual shares of the 500 companies, the manager can simply just buy a SPDR S&P 500 (SPY) index CFD to gain similar exposure, and at a fraction of the cost.
Furthermore, since CFDs mimic corporate actions taking place, a CFD share owner can potentially receive cash dividends, which can increase the trader’s return on investment. Most CFD brokers tend to offer products in all major markets worldwide, with easy access via their platforms.
CFDs allow retail traders to flexibly take long or short positions since the CFD market usually doesn’t have short-selling rules. As such, a trader can enter a short position without having any ownership of the underlying asset.
Lastly, CFDs offer a good and effective way to perform hedging in your portfolio. Hedging is important as the markets are usually volatile and a trader can never predict the direction of the markets.
As such, one can actively hedge to prevent yourself from any adverse price movements. For example if you are in long positions, CFDs can allow you to take short positions, in perhaps smaller position sizes to hedge your exposure.
By doing so, it can allow you to have proper risk management in the case that markets start to fluctuate.
The disadvantages of CFD trading
While leverage could accelerate profits for a trader, it could mean taking up bigger position sizes as well which can in turn amplify losses.
Traders need to make sure they are disciplined with risk management such that they do not risk too much of their portfolio in every trade as they could potentially lose all of their account balance and might lose more than what they have deposited.
However, in such scenarios, traders will typically get margin-called instead where brokers will force liquidate all their open positions once their capital falls to a certain level, to avoid negative account balance. It is also important to trade with a credible broker that is reputable and financially viable.
An example of a CFD
Assuming an investor desires to buy a CFD on the SPDR S&P 500 (SPY) and the broker requires a 5% margin as collateral for the trade.
Subsequently, the investor buys 100 shares of the SPY for $300 per share for a $30,000 position, of which only up to 5% or $1,500 of the initial capital is placed with the broker. Two months later, the SPY is trading at $350 per share, and the trader exits the specific position with a profit of $50 per share or $5,000 in total.
Consequently, the CFD is cash-settled, where the initial position of $30,000 and the closing position of $35,000 ($350 x 100 shares) are netted out, and the gain of $5,000 is credited to the investor’s account.
What are the risks of CFD Trading?
CFD trading is fraught with risks, especially as traders tend to use higher leverage, which significantly increases the risks of trading.
Furthermore, CFD trading is not available in every jurisdiction.
For instance, the USA restricts CFD trading altogether, however, it is available in other major financial markets such as the United Kingdom, Singapore, Switzerland, Germany, France etc. Countries like Australia have recently placed tighter restrictions in CFD trading, reducing the level of leverage that a broker can offer to retail clients.
For more information on CFD trading risks, read our article “What are the risks in CFD trading“.
Why is CFD trading illegal in some territories?
CFD trading is a form of over-the-counter (OTC) trading, where transactions happen outside of a regulated centralized exchange and take place between two counterparties, which makes it a lot harder to regulate than exchange-traded transactions.
In certain jurisdictions, CFD trading is prohibited because it is against their local securities law. In U.S, over the counter financial instruments such as CFDs are heavily regulated through legislations like the Dodd Frank Act and enforced by the Securities and Exchange Commission.
Furthermore, CFD trading entails leverage. Statistically, up to 90% of retail customers tend to lose 90% of their money in 90 days when engaging in CFD trading without guidance. CFDs can be wrongly used by gullible retail customers who take up excessive leverage and risk.
Final Remarks
CFDs can be helpful in providing exposure to the underlying assets without the high upfront capital cost to start investing. However, given the nature of leveraged trading in CFD,it requires a level of consistency, patience, discipline, and knowledge about markets to avoid significant losses.
Contact us at Ortega Capital for more information.
