CFDs (Contracts for Difference) have their origin in the early 90s of the last century, which is when they began to be traded in England. Since then they have spread throughout the world as one of the favorite speculation products of thousands of traders.
Let’s see their main features and how convenient or not it is to trade with these derivative instruments.
What are CFDs?
Basically, CFDs are contracts between a trader and a broker. Both parties agree to settle in cash the difference that occurs in the price of the underlying asset between the opening date and the closing date of the position (acquisition and settlement of the contract).
The underlying assets with which the trader can operate through CFDs can be commodities, currencies, cryptocurrencies, stock indices, and especially shares.
In reality, most Forex brokers for retail traders are Forex CFD brokers and do not offer real access to the underlying market.
The purpose of CFDs is to be able to trade with an asset, almost as if the trader were trading directly with it, but without having to disburse the total capital necessary if he were to buy or sell in cash and without having to access the underlying market directly. Therefore, CFDs can be said to be a type of derivative.
The trader only cares about price movements and how that affects his position.
Why choose CFDs over other instruments?
Those who prefer CFDs for trading often argue that they do so for reasons such as the f
- The way of trading with CFDs is quite flexible since they offer the possibility of trading up and down with long and short positions. If the trader buys a CFD, he will have a “long” position and if he sells it, the position will be “short” (short sale). The objective in long positions is “Buy low = Sell high” and in short positions, the aim is “Sell high = Buy low”.
- CFD trading offers leverage, which in the case of Forex CFDs can be quite high.
- They are a good tool for hedging against possible and foreseeable downturns in your main portfolio of securities.
- CFDs typically have a lower trading cost.
- CFDs give access to many and varied financial markets.
Later and below we delve more into these points.
Main characteristics of CFDs
|It is not necessary for the trader to have 100% of the total value of the position in his account to open a CFD trade.||CFDs are uncovered products in which we can buy or sell without having 100% of the resources and/or assets needed to open a trade.|
|There is no delivery of any underlying asset or instrument once the trade is settled. In other words, there is no real purchase or sale of the traded asset.||CFDs are not an asset trading transaction, but rather a settlement of differences between the initial and final price.|
|No limitations on the size of the position (for example, the number of shares bought or sold)||Each CFD has a reference asset. The trader can trade on any number of CFDs. (The broker can limit the number of CFDs to buy/sell on an underlying to avoid concentrating risks on any asset)|
|No predetermined expiration period.||It is the trader who decides the end of the trade.|
|To determine the overall result with CFDs, you have to wait for the closing and settlement of the position.||The sum of each day’s price changes (positive and negative) up to the time of settlement is the final result of the CFD deal. It coincides with the difference between the settlement price and the initial price, always multiplied by the number of CFDs in the trade.|
|CFD trading is done on margin and offers high leverage||Unlike direct buying/selling of shares and other instruments, CFD trading is done with margin and leverage, which in some brokers can even be as high as 1:500 for Forex.|
Margin in CFD trading
The issuer of the CFD requires the investor to put a guarantee or margin deposit to be able to trade with these products and ensure that the investor responds to possible losses. This money is basically the capital deposited in the trading account at the broker.
The margins of the CFDs are constituted and settled in the account of the broker that we have contracted. The margin amount is retained and blocked in this account.
The deposit amount is generally recalculated daily based on market closing prices and must be capable of supporting the value of the position at all times. If the market moves against the position and the accumulated losses exceed the margin that supports the trade, then the broker will request more funds as collateral in such a way that the investor must always maintain the minimum balance required.
Example of application of margins in CFDs. Leverage creates risky situations, so only experienced traders should handle it.
Margins are related to leverage. They usually represent a percentage of the total value of a position. The amount of the initial margin depends on the broker and the underlying market and is usually expressed as a percentage of the cash value of the trade. For Stock CFDs, the margin requirement can be as low as 5% of the position.
There are two types of margins, the deposit and maintenance margins. Deposit margins are used to open positions, while maintenance margins are used to limit losses during trades.
CFD as a hedge against possible losses.
CFDs are suitable as a hedging strategy against possible losses in our securities portfolio.
For example, if you have Apple shares in your portfolio that have reached a significant level of revaluation, and you anticipate that their price will fall, but you do not want to sell due to tax issues, you can short the Apple CFD, this effectively represents a short position even though you actually still own the shares.
How does CFD trading work?
CFD buy and sell orders are entered quickly and easily over the Internet in an OTC market through brokers, who act as intermediaries and market makers. Contracts for differences are neither traded nor registered in any organized market as in the case of futures.
When trading CFDs, as in all derivatives, what matters most is understanding how the underlying price moves in order to buy or sell accordingly and thus be able to earn money.
To find out how CFD trading works, we will take these key concepts:
Calculation of profits or losses.
To calculate the final profit or loss on a CFD trade we apply the following formula:
*Profit or loss = (number of contracts x value of each contract) x (closing price – opening price)
The final net result will be determined by deducting commissions or other expenses such as interest on financing.
The final net result will be determined by deducting commissions or other expenses such as interest on financing.
- If the trader buys (long position) he will get the difference as a profit if the price of the CFD goes up and on the other hand he will pay it as a loss if the difference of the underlying asset goes down. Here the trader has a bullish forecast of the price of the underlying asset. If the market does not meet this expectation, he will have to assume the corresponding losses.
- If the trader sells (short position) he will get the difference as a profit if the price goes down, but he will pay it as a loss if the price goes up. In this case, the forecast is bearish for the price of the underlying asset.
Example 1, suppose we buy 200 CFDs on share A at $3.00 per share:
|Day||Price per share||Trade||Settlement|
|Opening||January 15||3,00 USD||Buy|
|Closing||January 29||3,50 USD||Sell||(3,50-3,00) x 200 = 100 USD|
Since in this case, the price of share A rose by $0.50, then the position generates a gross profit of $100.
Example 2, now suppose we open a short position on stock B by selling 200 CFDs at $4.00 per share.
|Day||Price per share||Trade||Settlement|
|Opening||February 1||4,00 USD||Sell|
|Closing||February 15||4,50 USD||Buy||(4,00-4,50) x 200 = -100 USD|
In this example, since the market went up instead of down as the trader expected, the loss was $100.
Note: These are just examples, both long and short positions are valid to make a profit on the market with CFD.
CFD position sizes
The size of a single contract depends on the underlying asset being traded. This allows CFD instruments to replicate the way that underlying asset is traded on the market. This is possible because CFDs are traded in standard contracts or lots.
CFDs offer the possibility of trading a fraction of a share thanks to mini or micro lots. If we wanted to buy a share of AMZN, we need more than $3,000 for a single share; If, for example, our capital to invest were $1,000, the cash operation would be impossible.
With CFDs, the operation would be possible, depending on the broker, up to a fraction of 1/100 (0.01); this, in addition to margins, makes it possible to trade securities whose high value would otherwise not allow regular retail investors to trade with them.
Duration or expiration of CFDs.
CFDs usually have no expiration. This means that the trader will have an open position until he decides to close it either because the price has reached a profit target or a stop loss. Although it may also happen that the available balance in the account is not enough to cover the margin to keep a contract open and the broker proceeds to close the position.
In other words, CFDs offer the trader the freedom to close a position until the market indicates that all possible profit potential has been reached.
The main costs of CFD trading
Each CFD broker offers its own transaction fee rates. For this reason, it is normal to find different ways of applying these costs related to CFD transactions.
Costs derived from spreads
In general, the most usual is that the trader does not pay direct commissions in CFD trades, but the broker applies the spread. The spread is the difference between the Bid price (the price at which the broker buys) and the Ask price (the price at which the broker sells). The broker is free to set the difference it deems appropriate and that difference is what it will charge as the cost of the trade (their earnings).
The performance of CFDs is related to the spread. The greater this differential, the more you will need the price to move in your favor, that is, the cost to be recovered is greater.
Brokerage commission for direct market access (DMA)
In CFDs traded with execution with direct market access or DMA, brokers apply a direct commission per trade. This commission is usually a percentage of the total cash value of the transaction. In addition, they charge the client an additional commission for taking the order to the organized market (equivalent to the stock market fee and the costs of the clearing and settlement service).
Brokerage commission on the volume
There may also be cases in which the broker also charges a brokerage fee on the trade volume but also establishes a minimum in dollars for each trade. This means that if the resulting amount of the product between the percentage applied and the value of the trade does not reach a minimum amount, that amount would be charged.
Other costs to consider
Another cost to take into account is when we keep a position open from one day to the next, which is known as overnight financing (swap or rollover).
Most brokers do not typically charge a subscription fee for services that offer access to market data (such as stock market price data) when trading CFDs, but there are some that do, and you should have this present.
In any case, investors holding CFDs do not have to pay securities custody commissions.
In which markets can I trade CFDs?
There is a wide variety of underlying assets on which you can trade using CFDs:
- Foreign exchange
CFDs are a financial tool that allows an investor to access many markets without the need to trade directly in the underlying market. This offers the trader better liquidity and flexible execution.
It also provides the added benefit of short-selling when the market is falling. Remember that with CFDs you do not own the underlying asset.
Depending on the broker with which he has an account, the trader will have access to a greater number and variety of markets. There are brokers that only offer dozens of underlying assets to trade with CFDs, while others offer literally thousands, including emerging market shares.
Traditional investments (stocks, currencies, commodities, etc…) are generally more expensive in their respective markets than CFDs based on the same underlying assets. This means that the trader can create a diversified portfolio at a lower cost.
Trading hours for CFDs
The flexibility and time availability of CFDs is equal to that of the underlying assets on which these contracts are based.
So the trader will always be able to find something available to trade regardless of the time or day of the week. Of course, the moments of greatest trading activity are when the different underlying assets are being traded in their traditional markets.
What are CFD brokers?
As we have seen, CFDs are investors’ gateway to shares, commodities, currencies, bonds and much more. But it all starts with the choice of a CFD broker. Below, we take an in-depth look at the best CFD brokers, their features, descriptions, and much more.
CFD brokers are the issuers of the contracts and act as intermediaries between the traders and the market. They offer access to real-time prices, create the market (most are market makers) and handle the settlement of CFD trades.
CFD brokers provide the necessary trading software to connect traders to the CFD market, so the first step for a new trader will be choosing from a long list of potential brokers.
A broker acts as an intermediary. The trader places his trade with the broker and the broker places the trade on the market. Brokers are members of the market and you need a CFD broker if you want to trade this financial instrument. The degree of involvement of your broker depends on whether you choose a DMA broker or a market maker broker.
DMA brokers vs. market makers
DMA brokers are direct market access brokers and are one of the two main types of CFD brokers. A DMA broker allows its clients to trade the CFD markets but does not play a direct role in the execution of the trade. The trader places the order directly in the markets and waits for his buy or sell order to be matched with a corresponding order from a counterparty to complete the trade. The DMA broker makes its profit from commissions, and is basically an intermediary between the trader and the market.
A market maker is the second type of broker and is more practical than a DMA broker. Market makers brokers create the market in which CFDs are traded and are much more than just a portal between the trader and the market. The trader is governed by the prices of the market maker when making a trade.
Prices tend to be less advantageous with market makers compared to prices in real markets. These brokers make their profits from the spreads and charge a markup on the prices they get from their liquidity providers. However, there is a trade-off, as market makers absorb more risk and offer more real-time liquidity and information to traders. Market makers are also often quicker at executing orders; there are less delays because the broker and the market are the same. The role you want your CFD broker to play determines the type of broker you will choose.
Some brokers offer a hybrid model, acting as market makers on some of their trading accounts and DMA brokers on others.
Which CFD broker should I choose?
As CFDs and their markets are unregulated, it is important to choose a CFD broker that is properly regulated, reputable, longstanding, and offers access to a variety of educational and informational services, in addition to the brokerage itself.
The following is a short list of recommended CFD brokers:
|Broker||Regulation||CFD Contracts (underlying assets)||Minimum deposit||Broker review|
|FP Markets||ASIC |
|Avatrade||Central Bank of England|
FSA of Japan
-Stocks (including DMA Stocks CFD)
-Stocks (including DMA Stocks CFD)
You can access a complete list of recommended CFD brokers here: List of CFD Brokers
Stock CFDs: Dividends, capital increases, and distribution of premiums in CFDs.
The payment of dividends, capital increases, or return of premiums, normally involves a fall in the price of the shares. To guarantee the neutrality of this type of operation when trading CFDs, a specific treatment must be applied.
If we are long (a buy position) in a stock that pays dividends, we will receive a credit for the equivalent of the dividend. If our position is short (a sell position) we are charged the amount of the dividend.
In capital increases, if we are long, the investor is paid in cash 100% of the theoretical value of the right. If we are short, we are charged 100% of the theoretical value of the rights in cash.
The determination of the theoretical value of the capital increase rights will have to be carried out by a financial intermediary accredited to carry out this task.
In the return of issue premiums, if we are long, 100% of the issue premium or amount returned is paid to us in cash. If we have a short position, then we pay 100% of the premium in cash.
It is important to understand that these operations are a replica of those that occur with the underlying shares, that is, we are not the owners of the shares (underlying asset), we are not shareholders and therefore we do not have any rights associated with the shares.
What are the risks of CFD trading?
Among the risks associated with trading CFDs, we can find:
The lack of liquidity
If there are not enough trades in an underlying asset, it can cause your existing contracts to become illiquid. This would cause your CFD provider to request additional margin payments or close your contracts at unfavorable prices.
The increase in required margins
Most brokers in the face of changing market conditions (more volatility) increase the required safety margin. This is a problem, as we saw earlier, since we may be forced to close positions to meet those margins, having to assume possible losses of one or several positions to meet the new requirement.
The multiplier effect due to leverage
Like all derivatives, CFDs have a high level of risk due to leverage. This tool can be an opportunity to multiply your profits in expert hands, because in inexperienced and unwary hands they can, in fact, often cause significant and traumatic losses.
In CFDs, there is also counterparty risk since when trading these derivatives the only asset traded is the contract issued by the provider. This exposes the trader to counterparties other than the provider, including other clients with whom the CFD provider conducts business.
Let us remember that counterparty risk is the risk to which we are exposed in the event that the other party defaults on its financial obligations.
It is important to recognize that the CFD industry is not highly regulated and the credibility of the broker depends on its reputation, longevity, and financial position, which should compensate for the lack of greater control by an official regulatory body. There are excellent CFD brokers out there, but it is important to research a broker’s background before opening an account. There are countries, such as the US, where clients are currently prohibited from contracting CFDs.
Differences between CFDs and futures.
A priori both types of derivatives are very similar, we could think at first glance that they are the same, however, let us investigate the aspects in which they differ:
Cons of CFDs versus Futures
Futures are more transparent in pricing: Futures are traded on open public exchanges, plus they trade on a large, fairly liquid market. This provides more reliable access to prices that are a reflection of the value between the futures contract and its underlying asset.
For their part, the prices of CFDs are mostly calculated from the futures market price (although in many cases the prices of CFDs are also taken from the spot markets, as in the case of Forex and cryptocurrencies), which is their underlying, and later there is an adjustment process to adapt these prices to the broker; this causes more distortion for CFD prices than futures.
Lower profitability at higher volume: the application of commissions in futures is generally more profitable for those investors who handle high volume. In fact, the way of pricing futures transactions was designed to achieve more savings in transaction costs the more volume is traded.
Pros of CFDs versus Futures.
Increased Liquidity: Because CFDs are largely traded directly with the broker, it is normal for the broker to act as a market maker in situations where positions cannot be directly matched. This gives CFDs generally more liquidity than is the case with futures.
They have no expiration: the expiration is something intrinsically linked to futures, and this generates a natural fall in price, and the value gradually erodes the closer we get to expiration.
Not having an expiration is one of the greatest strengths of CFDs, since traders who trade with these derivatives do not have to pay attention to the expiration date or roll their position so that it remains open until the next expiration. However, as the futures, they use as underlying assets do expire, CFDs can experience significant volatility during these periods as a result of events in the underlying market.
Barriers to entry: futures are usually expensive and inaccessible to small investors. A CFD can be equivalent to a share in value, but this is not the case with futures, which may require a large amount of capital in the form of margins to participate in the market. That is why CFDs are more flexible and attractive to smaller traders.
Comparison of CFDs with other products
|Instrument||Buying shares on the stock market||Futures||CFD|
|Margin deposit as collateral||100%||25%*||1%-40%*|
|Low barriers to entry||No||No||Yes|
*The margin percentage depends on the futures exchange (futures contracts), underlying asset and the broker.
Is CFD trading really right for me?
CFDs are as good a product as any other to make big profits in the markets, although if you are a beginner and inexperienced trader, you should seek advice and educate yourself to know all its features perfectly. They are associated with a high risk because they are leveraged derivatives that can cause heavy losses when the market moves against them.
Take the opportunity to create a demo account, which some brokers offer, to trade CFDs and practice until you assess if you are ready to enter the market through a real account.
For which types of traders can CFD trading be suitable?:
- Those who want to diversify their portfolio. The great diversity of markets offered by CFD brokers gives the possibility and opportunity to trade in any market that you have previously planned to invest in.
- Those who seek flexibility for their investment strategy, from the most active to the most passive traders who want to take advantage of aspects of CFDs such as flexible hours, being able to open long and short positions, positions without expiration, etc.
- Short-term traders. Although they can be used for long-term trades, CFDs are usually used for short-term trades. Long-term position traders tend to be more inclined to buy stocks and apply “Buy and Hold” strategies.
- Traders or investors with insufficient capital to enter other assets or products such as futures or certain shares, can access the CFD markets with much less capital.
Frequently asked questions about CFDs. (FAQS)
Common questions when dealing with CFDs:
When trading CFDs do I own the underlying asset?
Contracts for difference (CFD) offer a way of trading in financial markets that do not require the purchase and sale of any underlying asset. CFDs allow the investor to trade with very little capital, although it is necessary to carry out an investor profile analysis to gauge whether these financial instruments are suitable for him.
What is a CFD?
A CFD or Contract for Difference is a cash derivative investment instrument, generally without expiration, that allows speculative transactions on price movements without owning the underlying asset.
What is the difference between CFDs and Forex?
The main difference between CFD trading and Forex trading is that CFD trading involves different types of contracts covering a diverse set of markets, such as indices, commodities, and cryptocurrencies, while Forex offers currency trading only. However, there are also CFDs that use currencies as their underlying assets.
What is a CFD broker?
CFDs are Over The Counter (OTC) products, and as the name suggests they are contracts for differences, that is, it is a contract between two parties that exchange the difference between the entry price and the exit price, multiplied by the number of contracts that were agreed upon.
One of these parties is the trader and the other is the broker, who issues the contract and handles its settlement and payment of profits (or collection of losses). The broker is also responsible for supplying the prices of the CFDs and the trading platforms where the CFDs are traded.
What are the best CFD brokers?
The best CFD brokers are those regulated by financial services regulators such as: