The abbreviation CFD stands for ‘Contract For Difference’, meaning that parties to the contract agree to pay the price difference of the underlying market. The underlying asset – a share, cryptocurrency or fiat currency pair, index, or commodity – acts as the basis for the contract. Since a CFD’s value derives from the price fluctuations of other financial markets, it is classified as a derivative.
How CFD trading works
The mechanism behind CFD trading is quite simple. The agreement takes place between a trader and a broker. Suppose the trader thinks that the value of a financial market will rise. They open a position to buy CFDs on this market, that is they ‘go long’ and if the price of the underlying asset increases, the trader profits. Similarly, if the trader predicts the asset value to drop, they sell CFDs, or ‘go short’.
However, if the trader predicts the market movement wrong, they have to bear the losses. The profit or loss equals the difference between the asset price at the beginning of the contract and its price at the end.
CFD trading: pros
A contract for difference is a leveraged financial instrument, which means you only need to deposit a percentage of the total trade value. This is referred to as the initial margin. The exposure of the deposited funds is then magnified, and the trader to bigger trades and potential profits.
Suppose your broker provides a 1:20 leverage for the chosen instrument. To be able to open a $20,000 position, you have to deposit only $1,000. In traditional trading, your investment equals your exposure.
In March this year, the European Securities and Markets Authority, or ESMA, introduced new leverage levels for retail CFD traders based on the volatility of the underlying asset. Capital.com became the first CFD broker to be totally compliant with the new restrictions. Our current leverage limits are as follows:
1:30 for major Forex pairs
1:20 for non-major Forex pairs, gold and major indices
1:10 for commodities except for gold and non-major equity indices
1:5 for individual equities and other reference values
1:2 for cryptocurrencies
A contract for difference is a more flexible financial instrument compared to conventional shares or commodities, etc. With CFDs, a falling market can become an excellent trading opportunity.
When you open a trading platform, you’ll see two buttons; ‘Buy’ and ‘Sell’. The latter means that you go short on a market, in other words you borrow it, sell it, and then buy it back to close the trade.
The key motivation behind short selling is the prediction that an asset’s price will drop, enabling to buy it back at a lower price to profit.
No stamp duty
CFDs are designed to track the underlying market. When you buy CFDs on Netflix shares, for example, you don’t invest in the company directly or own its shares. You just speculate on the price fluctuations.
If you are engaged in traditional share trading in the United Kingdom, you incur a stamp duty of 0.5% for holding assets. In this respect, CFDs are a clear advantage. As you don’t hold the underlying market when trading CFDs, you don’t have to pay the stamp duty.
CFD trading: cons
Ironically, the key advantage of CFD trading – leverage – is its main drawback as well. Using leverage means that a small initial deposit leads to much larger exposure. Once you leverage your investment position, you considerably boost both your potential profits and your potential losses.
If the market goes against you, and your margin dips below the agreed level, your CFD broker will send you a margin call, demanding that you either deposit more funds or close positions fully or partially. Short sellers are exposed to potentially limitless losses because the asset value can grow infinitely.
This is interest that you have to pay for holding a leveraged position overnight. It is calculated based on the CFD value and is deducted on a daily basis for every day that you keep your position open. However, the fee is not charged if you close the position before the overnight fee time, usually at 10 p.m. (UTC).
The charges for different underlying markets is calculated differently. From this short video you can discover how Capital.com gets its overnight fees for shares, indices, currency pairs, commodities and cryptocurrencies.
Lack of ownership
CFDs are about speculating on price changes, not about purchasing the underlying assets. So you own the contract, not the share, currency or commodity that the contract is based on.
In case of commodities, this can be a plus: you don’t have to find a place to store the purchased asset. But when it comes to shares, CFDs can be a less robust option compared to conventional share trading, As owning shares in a company gives you voting rights, and potential dividends.
To conclude, contracts for difference are financial instruments with inherent advantages and disadvantages. Consider them carefully before you embark on CFD trading.