Contracts for difference (or CFDs) are a type of derivative product that allows buyers and sellers to exchange the difference between the present price of an underlying asset and the price when the contract is closed. CFD trading can be used with a wide range of underlying assets, including equities, currencies, commodities and indices.
Similar to options, futures, or leveraged exchange traded funds (ETFs), CFD trading gives participants direct market exposure without having to take ownership of the underlying asset. CFDs are commonly compared to futures and options contracts as traders have the ability to profit from both long and short positions. To do so, CFDs are bought or sold outright. This functionality gives traders the ability to capitalise on either rising or falling price action.
Due to their flexibility, affordable pricing and asset class diversity, CFDs are ideal instruments for short-term traders. When coupled with regular volatility and liquidity, contract-for-difference products lend themselves well to countless short, medium and long-term trading strategies.
CFDs were first developed on the London Stock Exchange in the 1980s by market maker Smith New Court. The products emerged in response to interest from investors who wanted to be able to sell stocks short without having to first take the costly and complicated step of borrowing them.
The products attracted the interest of institutional investors and hedge funds, and several equity market makers began to offer them as over-the-counter products. CFDs later gained interest from individual investors and in the late 1990s, they were launched as a retail product by Gerard and National Intercommodities through its electronic trading system.
With the growing popularity of the product, several other UK and European institutions began to offer CFDs. Since that time, their use has spread to several other regions, including Australia, the eurozone, Russia, Japan, Canada, South Africa, Switzerland, Canada and New Zealand. CFDs in the U.S. are considered to be security-based swaps and are regulated under legislation governing swap trading. As of this writing, it's impossible to trade CFDs as a retail market participant in the United States. Free trade of CFDs is not permitted as no exchanges offer contract-for-difference products to the general public.
How A CFD Works
The contract for difference, as the name implies, is a contract between a buyer and a broker or other selling institution to exchange the difference between the purchase price on the contract and the price at which it is sold. Buying or selling a CFD serves as a proxy for buying or selling an underlying asset, without the need to actually exchange the asset.
If the price of an asset rises and the contract is closed, the seller of the CFD, or counterparty, must pay the difference between the current price of the shares and the price when the contract was made. However, if the price falls, then the buyer pays the price difference to the seller.
Thus, if the peroidic closing price of the underlying instrument rises, the buyer profits; and if it falls, the seller profits. As a contract, the CFD itself is not a tradable instrument. Equity CFDs have no fixed contract size or expiration date. Size and expiration for other types of instruments are based on the contract for the underlying asset.
CFDs are leveraged financial instruments, meaning that they are traded on margin. New positions in the market may be opened by depositing a small amount of the position's total value, thus satisfying preset brokerage margin requirements. Given the presence of enhanced leverage, employing sound risk management principles is a must for active CFD traders.
CFD margins are relatively low in comparison to other instruments. The reduced requirements permit traders to control large positions in a given market without being subject to extensive capital outlays. CFD margin requirements differ from broker to broker and vary according to the asset class being traded.
As an illustration of the reduced margins, assume that an equities specialist is interested in trading shares of Apple Inc. (AAPL.US). In order to buy a single share of AAPL, one must come up with the total current market price. If AAPL is trading at US$375 per share, then the cost of opening a one share position is US$375. However, with the AAPL.US CFD, the capital needed to gain market exposure may be as little as 2% of the position's aggregate value. Given a US$375 share price and 2% margin, a modest US$7.50 per contract is the initial capital outlay.
Go Long Or Short
CFDs can involve long or short trades. In a long CFD trade, a trader enters a contract to buy with the hope that the price of the underlying asset will rise. In a short CFD trade, a trader enters a contract to sell with the hope that the price of the underlying asset will fall.
In a long CFD trade example, a buyer could use a margin account to purchase 10,000 CFDs on an underlying asset trading at US$4.20, to obtain a position worth US$42,000. If the asset price rises to US$4.50, the contract can be closed at a position worth US$45,000, offering a gross profit of US$3,000. However, if the price falls to US$4, the trade will produce a loss of US$2,000.
Similarly, in a short trade, a seller could offer 10,000 CFDs on an underlying instrument trading at US$6.20. If the price fell to US$6 then the trade would produce a profit of US$2,000. If the price rose to US$6.50, the seller would see a loss of US$3,000.
The flexibility to take long or short positions in the market is especially useful for short-term traders. Traditional "buy-and-hold" investing strategies are designed for longer time frames, ranging from months to years. Being able to quickly become net-long or net-short a given asset class is useful for capitalising upon periodic swings in pricing. If a market unexpectedly rallies or crashes, one can trade CFDs and get in on the action.
With either of these types of trades, the trader entering the contract would also be responsible for any associated trading costs, including commissions, taxes and financing costs.
Advantages Of CFDs
CFDs are considered to be attractive because they can be obtained with low margins, meaning that the potential for leveraging gains can be large.
For the average retail trader, enhanced leverage helps to maximise capital efficiency. In effect, small amounts of money may be used to control vastly larger positions in the market. Consequently, many trading strategies that were previously too expensive become potentially viable. Among the most popular are scalping, reversal, trend, dollar-cost-averaging and reversion-to-the-mean methodologies.
FXCM's lineup of share CFD offerings are prime examples of leverage at work. In the case of Tesla Inc. (TSLA.US), FXCM furnishes traders with robust buying power:
- Estimated Share Closing Price: US$1500.00
- FXCM Micronization: 1/10
- FXCM Contract Value: US$150.00
- Required Margin: US$30.00
After micronization, FXCM's required margin for buying or selling one share of TSLA.US measures approximately 2% (US$30.00/US$1500.00). The reduced capital requirements enable risk-receptive traders to buy or sell large blocks of Tesla Inc. without realising the US$1500 per share cost.
The modest initial capital outlay required for share CFDs warrants a strong risk management gameplan. Conservative money management, the use of stop loss orders and addressing risk to reward on a trade-by-trade basis are a few ways to limit market exposure. Although those that trade CFDs may realise extraordinary rewards, it's important to quantify and always be aware of assumed risk.
CFDs can be granted tax advantages in some national trading jurisdictions. In the U.K., for example, CFDs are exempt from the "stamp duty" charged on traditional equities trading. Any losses incurred with CFDs can be used to offset payment of capital gains taxes on profits.
Tax situations differ on a case-by-case basis, from basic to extremely complex. Futures, forex, options and stocks all have unique parameters, while CFDs may be used to simplify one's liabilities through trading targeted asset classes via a consistent transactional framework.
However, no matter what instrument(s) are being targeted, a trade or investment's time horizon is an integral part of determining tax liabilities. In many cases, proceeds from short-term positions are taxed at much higher rates than longer-term investments. Ultimately, the responsibility falls upon the trader to be aware of local tax laws and reporting duties.
Risks of CFD Investing
Because CFDs can be obtained with low margins, they can expose traders to the potential not only for large gains, but also to large losses. Thus, traders should evaluate their tolerance for possible losses before engaging in CFD trading.
The quintessential "double-edged sword," leverage is a tool that must be applied with discipline and respected at all-times. In the case of CFD trading, the reduced margin requirements afford traders an opportunity to open positions well in excess of cash-on-hand. This exposes the trader to a number of scenarios that may lead to significant losses:
- Position Liquidation: Upon a trade incurring losses that exceed the initial margin and all available funds, the broker may liquidate the open position. In turn, any and all losses stemming from the trade are immediately realised.
- Margin Call: If losses are severe enough, the trader will receive a margin call from the broker. A margin call is a request to deposit additional funds to the trading account for the facilitation of open transactions. In the event that it is met, trading may resume as normal.
- Account Closure: If margin requirements are violated repeatedly or margin calls go unanswered, the broker may close the trading account.
It's important to remember that the low margins of CFDs bring with them a number of consequences. However, when used within the context of a comprehensive risk management plan, haphazard leveraging may be avoided.
In addition to possible losses, CFD traders will need to consider other associated costs, including commissions to brokers, account management fees, taxes and overnight financing costs. For each day that a position is open, the contract holder may need to pay an interest charge on the notional value of the contract.
From a trader's perspective, there are two primary costs local to CFDs:
- Spread: CFDs are quoted in two prices, the buy (bid) and the sell (ask). The buy is the price in which one can open a long CFD position, and the sell is the price where one can open a short position. Buy prices will always be moderately higher than sell prices, creating a buy/sell spread. The spread represents a sunk cost; in reality, the trade's closing price must overcome the spread for the position to be profitable.
- Commissions: Commissions are brokerage fees that are applied on a trade-by-trade basis. Commissions vary per broker and market, with the cost coming in addition to the bid/ask spread.
To sustain consistent profitability, efficient traders minimise the costs associated with spreads and commissions. While trading costs are unavoidable, focussing on ideal markets and comparing brokers are key elements of conducting business competently.
Liquidity And Execution Risks
Along with costs and loss risks, there may be other risks associated with CFDs. These include liquidity and execution risks. Liquidity risk is the risk that an asset may not be available to trade at the price or quantity desired. Similarly, execution risk arises when there is a lag between the time when an order is placed and the time when it is executed.
CFDs can allow investors to speculate on rises and declines in asset prices without holding the assets in question, and leveraging gains on a small amount of initial investment through use of margin accounts. CFD traders, however, may be exposed to market, liquidity and execution risks in addition to costs that can cause losses or diminish potential profits.
This article was last updated on 16th September 2020.