A CFD (contract for difference) is an agreement between two parties to exchange price differences between the opening and closing prices of the contract. CFDs are financial derivatives meaning that their price is based on an underlying asset which could be a specific stock, currency pair, commodity or even other derivatives as well.
A CFD can be referred to as either “contract for difference” or “contract for differences”, both terms mean exactly the same.
CFD trading does not involve ownership of the underlying asset, it’s merely an exchange of the price differences based on the price of the underlying asset itself.
Here's what we'll talk about during our guide:
A financial derivative is a type of financial contract that has its price based on something else, and that something else is what we call the underlying asset of the contract.
So for example, there are several ways to trade any given company’s shares, but these are the most common:
- Buying or selling the real asset itself, shares that are traded on an exchange.
- Buying or selling options based on those shares (another class of derivative).
- Buying or selling CFDs that are based on the price of those shares in order to speculate on the price movements.
How are CFDs different from traditional assets?
CFDs are financial derivatives, their main difference with any other asset is that they do not involve ownership of the underlying asset in the contract. Let’s compare using shares:
CFDs Vs. Shares
|No ownership involved
||Ownership of the share itself
|No voting rights
||Depending on the share type there could be voting rights
|Entitlement to dividends is optional depending on the broker's policy
||The right to collect dividends depending on the share type and the company’s decision
|Shorting does not require finding borrowed stock
||Shorting requires finding borrowed stock at a premium
|CFDs are typically traded using financial leverage which carries overnight costs
||Shares can be held for years at no cost assuming there was no margin trading involved
A practical example
If you’re trading equity (such as traditional shares) you know that when you click “buy” on your trading platform, you bought a share, you own it. This means that you’re entitled (depending on the share type) to benefits, dividends or voting rights.
You also know that if you wanted to get rid of your stock, you can click on the sell button and this means that you sold something you previously owned and successfully managed to get rid of it, you no longer own the stock.
When trading CFDs in any broker’s trading platform, you’ll also notice that you have the same buttons: buy or sell, and this is where the confusion starts for most people, these buttons don’t operate in the same way as they do when trading traditional shares.
The Buy Button
On a CFDs trading platform, the buy button performs the action of going “Long”, which means that you’re expecting the asset’s price to rise in order for you to gain that difference in your favour by the time you close your trade
Notice we said “close trade” and not just “sell”, that is because most trading platforms offer a specific dedicated button to close the trade automatically, we’ll explain the process as we move on through the guide.
The Sell Button
In a CFDs trading platform, the “sell” button is used to open a “short trade” which means you’re expecting the price of a particular asset to go down so you can profit while it goes down, or lose if it goes up.
We understand this sounds like dark magic but it's not, we’ll explain it in a bit, the most important thing is to never EVER confuse this button with the normal function that it has when you’re trading real equity such as traditional stocks. This happens to a lot of beginners and they fail to realise they’re not actually selling something they owned, they’re just opening “short” trades.
How does CFDs trading work?
CFD trading allows traders to execute short or long transactions directly between them and the broker precisely because they are an OTC (over the counter) derivative, so in CFDs the transaction never takes place in an exchange. Before we get to what is OTC, let’s talk about the functioning logic behind CFDs:
Going Long using CFDs
Imagine that every moment right before you click the “buy” button on your CFD broker, you send them a text message that says: “Let's open a long contract, if by the time we close it, the price is higher than when we opened, you’ll pay the difference in my favour, and if the price is lower, I’ll pay you the difference as it will be my loss”.
That’s literally what you’re doing with your broker, except it happens in a much faster and electronically automated way.
Going “Long” simply consists of entering a contract where you win money if the price is above the open price of the contract and you lose money if the price is below the open price of the contract, that’s why they’re called contracts for difference, you’re exchanging the price difference.
An example of a long (buy) trade using CFDs would be:
- The price of any given share is trading at $50
- A trader opens a long trade at the current price
- If the share’s price climbs to $60 and the trader closes his trade, he profited $10.
- If the share’s price falls to $40 and the trader closes his trade, he loses $10.
The previous example did not take into account commissions or fees, we’ll discuss them further in our guide.
Going Short using CFDs
Imagine that every moment right before you click the “sell” button on your CFD broker, you send them a text message that says: “Let's open a short contract, if by the time we close it, the price is lower than when we opened, you’ll pay the difference in my favour, and if the price is higher, I’ll pay you the difference as it will be my loss”.
Entering a short trade using CFDs is placing a bet on the price of an asset going down but in a much more efficient and simple way compared to doing it with traditional equity, which is a process we’ll describe later on during this guide.
Summarising, going short on CFDs is a method used by traders that expect the price of an asset to go down and they want to profit from that downwards movement.
An example of a short (sell) trade using CFDs would be:
- The price of any given share is trading at $50
- A trader opens a short trade at the current price
- If the share’s price falls to $40 and the trader closes his trade, he profits $10.
- If the share’s price climbs to $60 and the trader closes his trade, he loses $10.
The previous example did not take into account commissions or fees, we’ll discuss them further in our guide.
Where are CFDs traded and how are they different?
In order to understand why CFDs are an OTC derivative and why they are different to shares we need to analyse some very particular differences in their customizability and places where they can be traded.
Where are shares traded?
Stocks, futures and options are traded on exchanges, such as the NYSE (New York stock exchange) or many others, so this means your broker is just a middleman connecting you to that particular exchange so you can coincide with other buyers or sellers and perform buy or sell transactions.
Exchange traded assets are subject to particular criteria or requirements, for example, an exchange can dictate that a gold future can only be of 100 ounces per contract, so if the price of gold is $2000 you do the math, that’s a $200.000 futures contract.
Where are CFDs traded?
CFDs are highly customisable OTC derivatives, so they’re just being created and customised by your CFDs market maker broker.
Instead of having a minimum $200.000 contract, they can create a 0.1 ounces of gold CFD based on the price of the real future contract, and that’s why many of the CFD market maker brokers allow fractional share trading.
Now you understand, an OTC derivative is traded off-exchange directly between two parties (you and the broker) and it can be configured as the broker decides.
Shorting using CFDs vs traditional assets
By now we understand that shorting means attempting to make money when an asset price is going down, but, have you ever thought of the process involved to go short on an asset?
If you haven’t then we’ll show you an example of shorting with a physical commodity in comparison to shorting with commodity CFDs.
Shorting with a physical commodity (oil):
- Tom has 200 barrels of oil in his house which he doesn’t plans on using
- Mark wants go to short on oil because he saw some news and now believes the price of oil can fall down
- Tom doesn’t cares about the price of oil as he just uses it occasionally to produce stuff, so Mark decided to ask Tom to borrow him the oil
- Immediately after receiving the 200 barrels of oil, Mark proceeds to sell it at $200 per unit.
- Mark has $40.000 in cash
- Breaking news cause the price of oil to go down to $10 each barrel
- Mark buys 200 barrels using barely $2.000 (thanks to the oil price falling from $200 each to $10 each Mark could buy them back at a very cheap price)
- Mark proceeds to return the 200 oil barrels to Tom which was their initial agreement
- Mark profited $38.000
All of this assuming there were no costs for lending the oil, storage, transportation, etc.
Shorting with a commodity CFD (oil)
The process literally consists of going into an online trading platform, choosing the quantity of the contracts for difference (CFDs) based on the asset you want to short and clicking the sell button.
The difference here is that you don’t own anything, you only have a speculative contract where you agreed to exchange price differences with your broker.
Leverage on CFD Trading
Financial leverage is the equivalent of trading on steroids. It means that you can amplify your buying bower by a factor that your broker has pre-set, for example: if the broker says your leverage is 1:10 it means that per each dollar you have, you get the buying power of ten dollars ($10).
The reason for leverage to exist is allowing investors to amplify their trading capabilities and for the brokers that act as lenders to make money by charging an interest on the borrowed funds. This fee is called “overnight fee”, but we’ll get to that in a minute right after we talk about margin.
Margin on CFDs and how to calculate it
The Margin is the required amount of funds to open and to sustain open a leveraged trade.
You can also view it as a collateral deposit you set aside in order to cover the price fluctuations on your leveraged CFD trade.
How to calculate margin:
In this example you’re trying to buy $50.000 worth of oil, and your leverage is 1:10
Apply the following formula:
And now you got it, the value of your trade, divided by your leverage, equals your margin, which is the required amount of money to open and maintain open that position by your broker.
Hedging using CFDs
First of all, what is hedging? Hedging is a defence strategy where traders find ways to cover a particular investment or trade they have open by also trading another asset that usually has an inverse price relationship.
For example, a trader going long on the S&P 500 CFD future, might want to also purchase contracts of the VIX (volatility index) in the form of CFDs to cover himself. Here's why:
It’s a known fact that when the S&P 500 crashes, the VIX rises.
The VIX is an instrument that many investors view as an insurance policy against stock market crashes.
Note that this is just one particular example of a hedge, there are several strategies that traders use to cover themselves.
Advantages of CFD Trading
- The opportunity of being able to leverage yourself and gain the possibility of larger profits (along with larger losses also) using less capital.
- Highly configurable and customisable contracts that allow small traders to bypass the standard requirements of exchange traded contracts.
- Shorting assets with a one click and very little associated costs in comparison to executing shorts with traditional assets.
Disadvantages of CFD Trading
- Lack of transparency from a big portion of the brokers providing these services.
- The majority of CFD providers are market makers and some of them are not very clear on how they generate revenue or their conflict of interests policies.
CFD Trading Costs
The most common costs of trading CFDs are usually: commissions in/out of trades, spread, overnight fees or swaps.
Not all brokers charge the same fees, some can charge a particular combination of these, it depends on each case.
They are charged every time you open a trade and you close a trade.
Usually this commission is pure pain, as for example if the minimum in/out commission of American Stocks CFDs is $10 on a particular broker, that means that if you open a 100 shares long trade and then you decide to close it partially by selling 50, then 50 more, you’ll have paid $30 in commissions.
Luckily this commission is not charged by many brokers nowadays, yet the funny thing is that usually when they charge it, it's because they provide better execution than their competitors and have less conflict of interest against traders. Remember, nothing is really free in this life.
The spread is the difference between the buy and sell prices (bid and ask) and is precisely the reason why each trade opens in minus.
Let’s say that we have the following prices:
The spread is the difference between those two prices, in our example is $10.
As we mentioned before, in CFD trading sell means “short” and buy means “long”, so ask yourself this question: are the prices offered in the previous example convenient for me?
No they’re not, they are marked up thanks to the spread.
- Shorting at $50 when the buying price is at $60 means that you’re paying $10 in spread right from the start.
- Buying at a $60 price when the selling price is at $50 means that you’re paying $10 in spread right from the start.
In both prices you’re starting your trade with a disadvantage and that’s how market maker brokers make money, by quoting the buy and sell prices with spread in the middle.
Overnight fees or swaps
Overnight fees or swaps are the cost for using borrowed money or in other words, they are the interest rate that you get charged for the opportunity of having a leveraged trade open for longer than a day.
For example, your broker will quote two different percentages for the overnight fee in long or short positions, and that percentage of your total investment value is what you’ll get charged on a leveraged trade per night if it stays open.
Usually, with CFDs Market Makers, if you have 500 euros in your account and you open a leveraged trade with total value of 200 euros where you only had to use 20 euros as margin, you’ll still get charged the overnight fee based on those 200 euros, regardless of the fact you had 500.
In traditional equity trading, you get charged the moment you use funds above your current balance, for example, if you open a trade that requires 700 euros and you only have 500 euros, you’ll get charged the overnight fee on those 200 euros extra above your balance, as that is the borrowed capital. This depends on each broker, so always be sure to check it out.
What assets can you trade with CFDs?
No matter how obvious this question sounds, rest assured we have an interesting point to mention. Earlier on, we mentioned that you can trade shares, indices, commodities, currencies, cryptocurrencies, ETFs and many other assets based on CFDs, right?
Well, we also mentioned options and futures, and this is something very important to point out, because sometimes a lot of beginners are trading double derivatives without realising it.
The Double Derivatives
If an oil future is based on the price of physical oil, then a CFD on oil futures is a double derivative, here's why:
We must always pay attention to which is the underlying asset behind a derivative until we can reach the bottom of the chain and study the underlying asset in question.
CFDs are a powerful tool in a trader’s portfolio when used correctly.
The ability to go short in a few clicks without having to go through the trouble of locating shares to borrow at a premium is quite an advantage.
Another great use case for CFDs is hedging portfolios, for example: using them to cover a long position in shares in case an earnings announcement goes wrong and doing so at a fraction of the cost required to do it with traditional shares (thanks to financial leverage).
CFDs are quite a misunderstood financial tool due to the current industry situation. On one side we have reputable brokerage firms providing CFD trading at the highest standards possible. On another hand we have unethical market players trying to abuse this tool while using it to take advantage of uninformed traders.
The most important point to remember when trading CFDs is that the broker that a trader chooses will have a great impact on the quality of his experience. CFDs themselves can’t be either good or bad, the provider is the one that needs to be chosen with great care to ensure we can reap the maximum benefits out of contracts for difference.