The ChoosaBroker Trading Academy

2.5. An Introduction to CFDs

CFDs are a widely-popular financial instrument, ideally suited for participants with shorter time horizons. Trade with CFDs from anywhere, anytime, in markets spread across the globe that till a few years ago was outside the range of the average, retail trader.

What are CFDs?

A contract for difference (CFD) can be defined as a contract between a “buyer” and a “seller”, whereby the seller is obligated to pay the buyer the difference in the current price of an underlying security and its value at the time of entering in to the contract. If the difference is negative, the buyer will instead pay to the seller. CFDs are in effect leveraged derivative products that are primarily utilized by traders to speculate on the price of the underlying financial instrument moving up (long positions) or moving down (short positions). CFDs are available for stocks, indices, currencies, bonds and commodities. However, unlike other popular derivative contracts like futures and options, CFDs don’t carry any expiry dates.

A Brief History of CFDS

Like most financial derivatives, CFDs are fairly recent innovations that were originally created to fulfil the needs of a particular class of investment clients. The first Contract for Difference is widely attributed to Jon Wood and Brian Keelan, both of UBS Warburg, London, who designed the instrument in the early 1990s to help fund British conglomerate Trafalgar House’s bid for Northern Electric. During the initial years, CFDs were primarily used by hedge funds and institutional investors to cost-effectively hedge their equity exposure in the London Stock Exchange. Since no physical shares changed hands, these large investors, through the systematic use of CFDs, were able to avoid UK stamp duty and reduce their cost burden.
CFDs were introduced to retail traders in 1998. By the turn of this century, retail traders realized that the real benefit of trading CFDs was not the exemption from transaction tax but the availability of significant leverage. This brought about a rapid jump in trading volumes. CFD providers, sensing the opportunity, quickly expanded their offering from a few blue-chip stocks on the London Stock Exchange to include a diverse array of underlying assets like global stocks and indices, currencies, commodities and bonds. According to estimates from Boston-based research firm Aite Group LLC, the daily global trading volume in CFDs stood at roughly $75 billion by the end of 2017, with the figure likely to climb to a whopping $94 billion by 2019.

Features of CFDs

  • Most CFD contracts are unlisted, with trading being carried out over-the-counter through a network of brokers and market makers.
  • CFD assets are never physically bought or sold.
  • Since CFDs don’t have any expiry date, there is no time-decay.
  • The entry threshold is low because the contracts are highly leveraged, typically requiring upfront margin of as little as 5% of the total contract value.
  • The minimum contract sizes are also relatively smaller as compared to futures.
  • Since CFD contracts are not restricted by exchange definitions or jurisdictional boundaries, they don’t require the payment of any exchange fees or stamp duties.
  • See the best CFD Brokers in our review section

How Do CFDs Work?

Let us look at a simple example to better understand how the instrument operates. Shares of British company XYZ are currently trading at 48 / 50 (where 48 pence is the bid rate and 50 pence is the ask rate). After due analysis, you reckon the shares are on the verge of a short-term upside breakout and initiate a long position by buying 5000 CFDs, or “units” of the underlying stock at 50 pence. If your broker charges a 5% margin rate for company XYZ, you will have to deposit 5% of the total trade value as position margin. Thus, in this example your position margin will be £125 (5000 units x 50p = £2500 x 5%).
Let us assume that your forecast was accurate and the price gained over the next one week to 58 / 60. You decide to close out the long trade by selling an equal number of contracts at 60 pence. The share price has moved in your favour by 10 pence, from the initial buy price of 50 pence to the current sell price of 60 pence. Multiply this by the number of units you purchased (5000) to arrive at a profit of £500 for this trade.

Benefits and Risks of CFD Trading

Let us look at a simple example to better understand how the instrument operates. Shares of British company XYZ are currently trading at 48 / 50 (where 48 pence is the bid rate and 50 pence is the ask rate). After due analysis, you reckon the shares are on the verge of a short-term upside breakout and initiate a long position by buying 5000 CFDs, or “units” of the underlying stock at 50 pence. If your broker charges a 5% margin rate for company XYZ, you will have to deposit 5% of the total trade value as position margin. Thus, in this example your position margin will be £125 (5000 units x 50p = £2500 x 5%).
Contracts for Difference (CFD) provide a flexible alternative to traditional financial assets and have become a widely popular investing and trading vehicle. To profit from CFD market, you should have a thorough understanding of both the inherent advantages and the risks before putting real money at stake. Armed with adequate knowledge, traders can take full advantage of the numerous benefits that CFDs have to offer while limiting the potential downsides.

Benefits of CFD Trading

  • Profit in Rising and Falling Markets

CFDs allow a trader to initiate both long and short positions. This creates greater trading opportunities. Academic studies have shown that financial markets tend to trend almost 70% of the time. When an underlying asset’s price is trending higher, a trader can profit by placing a long trade. When prices are trending lower, going short, without fighting the broader trend, is the prudent strategy.

  • Leverage

    Leverage enables traders to open a CFD position by committing only a fraction of its actual value. When used with proper money management techniques, leverage can be a great tool to create wealth, especially for small retail traders, who don’t have large starting capitals.

  • Portfolio Diversification

    Most CFD brokers offer a wide range of underlying assets ranging from equities, indices, commodities and Forex pairs. This ability to invest and trade across different markets help a trader diversify his investment portfolio. When a portfolio is well-diversified, the risk is also spread out; meaning underperformance in one market often gets offset by strength in another. One of the major CFD brokers is Plus500, but other major players such as IG, City Index and Pepperstone are worth considering.

  • The Ability to Hedge

    CFDs are a cost-effective tool to hedge your open positions. Hedging limits potential losses in the event of market moving against you. For example, if you have a long position on a stock whose price suddenly tumbles, opening a position in the opposite direction using a short CFD can put a cap on futures losses.

  • Small Lot Sizes

    CFDs have relatively smaller lot sizes when compared to the more traditional assets. As a result, the capital requirement is also significantly lower, allowing greater retail participation.

  • No Underlying Ownership

     

    CFDs do not stipulate that a trader own the underlying asset. The advantage to such a structure is that the trader does not carry the risk of having to take possession of the physical asset.

Risks of CFD Trading

  • Over-Leveraging
By far the biggest mistake that beginner traders make is to think that CFDs are a short cut to wealth. When they are given the opportunity to place leveraged trades, many newbie traders abuse the opportunity, only to return with massive losses. Leverage is a double-edged sword. It can magnify both returns and losses. However, the tendency to over-leverage can be easily avoided by proper risk management techniques like never risking more than 5% of your trading capital on one single trade. Hitting a ‘home run’ is a recipe for failure. The idea should be to achieve long term consistency.
  • Market Risk

    In financial markets, asset prices can move swiftly and unexpectedly due to factors such as macro economic news, corporate announcements, geo-political tensions or natural disasters. Such types of risks are called market risks. There is no way a trader can escape this innate market characteristic. However, he can adjust his trading approach by taking in to account his risk tolerance in case the market moves against him. Money management strategies like initial stop losses and trailing stop losses are essential to counter market risk.
  • Counter-Party Risk

    Counter-party risk is a risk that the party with/through which you are entering in to a trade may fail to fulfil its obligations. CFDs are “over the counter” products. When you long or short a CFD, the only asset you are trading is the contract issued by your CFD provider. As such, the CFD provider becomes your counter-party. Counter-party risk is especially prevalent when you operate through a broker, who is under-capitalised and unregulated. This makes it important that you trade only with reputable, adequately capitalized, and properly regulated brokers.
  • Lack of Voting Rights

    Long term equity traders often complain that CFD contract holders do not get the right to vote during the underlying company’s Annual General Meeting. This is considered a significant risk because once a position is initiated; the investor is powerless as regards the future policy direction of the company. There are a number of brokers that are focussed on CFDs such as Plus500 or City index. In addition, we recommend reading the section on Best CFD brokers for further insights.

Ready to start trading? Check out the best CFD brokers and day trading brokers!

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