Contract For Difference (CFD)
What is a contract for difference?
Looking for a CFD definition? The term CFD stands for a ‘contract for difference’ – an agreement, typically between a broker and an investor, that one party will pay the other the difference between the value of a security at the start of the contract, and its value at the end of the contract. If the market moves in the direction you predicted, then you profit from the price difference. But if the market goes against you, the difference is deducted from your trading account balance.
Where have you heard about contracts for differences?
CFDs were originally traded among financial institutions, such as banks. But in recent years, they've become more popular with retail investors because they allow you to trade without having to own any securities yourself. Lots of novice investors have heard about this and now want to know: ‘What is CFD trading?’
As they become more popular, CFDs are increasingly coming under regulatory scrutiny, and you may have heard about moves to tighten oversight of them. In October 2017, Euromoney reported that providers of CFD trading services had launched a staunch defence of their business, with many welcoming increased interest from regulators.
What you need to know about contracts for differences?
As the CFD definition says, a contract for difference is made between an investor and a broker, and just like stocks it is traded on an exchange. But there’s one big difference: when trading a CFD on an asset, you don’t own this asset.
CFDs don’t have an expiry date like options or futures contracts. A CFD is effectively renewed at the close of each trading day and rolled forward if desired. Traders can keep their position open indefinitely, so long as there’s enough margin in their account to support the position. While the contract remains open, the account with the provider is debited or credited to reflect interest and dividend adjustments.
Very few fees are charged for trading a CFD, and many brokers don’t charge commissions or fees of any kind to enter or exit a trade. Instead, the broker makes money by making the trader pay the spread. To buy, a trader pays the ask price, and to sell/short, the trader must take the bid price.
A CFD trading example
Let’s take an example: you’re an investor, and you’ve noticed that up-and-coming tech company Omnicorp has been thriving recently. You reckon that the shares will go up in price. So how can you profit from this predicted price movement? Traditionally, you might have bought a bunch of Omnicorp shares and waited for them to rocket in value. But would it be worth the wait if the price rise turns out to be minimal?
Another option is to buy a CFD on this share and take a long position. If the price goes up as forecast, you get the difference between the opening and closing prices. The higher the price goes, the more money you’ll get.
On the other hand, if you reckon that Omnicorp is heading for disaster and the share price will crash, you can sell CFDs on Omnicorp’s shares and go short. The lower the price goes, the bigger your profit will be.
A CFD allows you to access global markets sitting in one place. Traders have easy access to any market that’s open from the broker’s platform. Because of stock, index, treasury, currency, commodity and sector CFDs, traders of many different financial vehicles can benefit.
CFDs are available in Australia, New Zealand, Canada, Japan, Hong Kong, Singapore, and in various European countries including Austria, France, Germany, Ireland, Italy, the Netherlands, Spain, Switzerland and the UK. But they aren’t permitted in a number of other countries, notably the United States, where rules about over-the-counter products mean that CFDs can’t be traded by retail investors unless on a registered exchange – and there are no exchanges in the US that offer CFDs.
CFD brokers operate in a market that, in general, is less regulated than those where actual securities are traded. And the CFD market isn’t bound by minimum amounts of capital or limited numbers of trades for day trading. But it’s worth remembering that because the CFD industry isn’t highly regulated, the broker’s credibility is based on reputation, life span and financial position. As with any trading decision, it’s crucial to investigate whom to trade with and which broker best meets your trading requirements.
Pros and cons of CFD trading
One of the big advantages of a contract for difference is that you can buy (go long) or sell (go short) on margin. In other words, if the margin is 1:10 you must pay just 10% of the share value. Imagine you’re planning to buy 100 Omnicorp shares with a total value of £10,000. Trading CFDs on these shares means that you can purchase them with just £1,000. So, where does the rest of the money come from? Brokers – they make your deal a reality. In the end, you own 100 Omnicorp shares with a total worth of £10,000 thanks to leverage.
But there’s one thing to bear in mind – if you hold a CFD position overnight, you’re charged an overnight fee. Don’t forget about that.
So CFD trading is far cheaper than trading real assets, and it helps to earn real money on price movements. It gives access to blue-chip shares like Apple, Google and Amazon, and to top trading commodities like gold, silver and natural gas.
CFDs also provide higher leverage than traditional trading. Standard leverage in the CFD market is as low as a 2% margin requirement and as high as a 20% one. Lower margin requirements mean less capital outlay and bigger potential returns for traders. But remember that leverage can expose you to greater potential risk, as well as rewards, if you get it wrong.
So, what happens if your trade moves against you? In that case, you lose the difference in price times size. But, no matter how great the price change is, you cannot lose more than you invested. When trading CFDs you are safe from a negative balance.
Don’t forget, though, that any kind of trading involves risk. And you should note that because each day a trader holds a long position costs money, a CFD isn’t suitable for buy-and-hold trading or long-term positions.
Find out more about contracts for difference
Our comprehensive glossary features definitions for a wide range of terms connected with ‘what is CFD trading’ such as securities, margin, risk and leverage. You can also watch our 3-minute YouTube video that explains ‘What is CFD?’ – watch it here. It covers all the ground we’ve just explored, with easy-to-follow graphics that explain every step of the way.
The European Securities and Markets Authority (ESMA) has published a Q&A document on the application of the Markets in Financial Instruments Directive (MiFID) to the marketing and sale of financial contracts for difference and other speculative products to retail clients. If you’re interested in learning about regulatory scrutiny of CFDs, you can read it here.