What are CFDs?

If you’re curious about what Contracts for Differences (CFDs) are and how to use them when trading or investing, you have come to the right place. In this article, Benzinga will explain everything you need to know about CFDs, including what they are, how they work, the different jurisdictions where you can legally trade CFDs, and the various advantages and disadvantages associated with using them. 

By the end of the article, you should have a solid understanding of what CFDs are and whether this useful financial product aligns well with your trading strategy or investment goals. Read on now for more information about CFDs. 

How Do Contracts for Differences (CFDs) Work

At its core, a CFD is a derivative financial instrument that enables traders to speculate on the rising or falling movements of an underlying asset without actually owning the asset itself. When trading CFDs, the two counterparties agree to exchange the difference between the opening and closing values of the underlying asset in cash.

This agreement is reflected in a contract between the trader and the CFD provider known as a contract for difference. The primary benefit of CFDs lies in their flexibility since they allow traders to profit from both bullish and bearish market conditions.

CFDs also offer traders exposure to various securities across multiple global markets. This can make them an attractive option for portfolio diversification purposes.

Since CFDs are not legal to use in all jurisdictions or offered by all online brokers, however, you will need to make sure that they are available for you to use. 

Countries Where You Can Trade CFDs

While there has been increasing interest in CFD trading worldwide, regulations vary significantly among countries and jurisdictions. To allow residents to legally participate in CFD transactions, a country must permit them to participate in listed OTC markets, or over-the-counter (OTC) markets that allow CFD trading.

European countries where CFDs are legal include, Germany, France, Italy, Spain and the UK, currently allow CFD trading. Outside the borders of Europe, countries like Australia, Canada, South Africa, Japan, New Zealand, Singapore and Switzerland also allow CFD trading within their jurisdictions. 

U.S. citizens need to note that CFDs are currently not available for trading within the United States due to tight regulatory constraints in the country. These restrictions stem primarily from concerns surrounding investor protection and systemic stability.

Still, many other countries permit CFD trading, offering ample opportunity for those living in them who are interested in exploring this popular form of derivatives trading that is usually done through secured margin trading accounts held with online brokers.

However, even if CFD trading is legal where you live, the regulations and specific rules governing it may vary across these nations, so be sure to do further research applicable to your specific jurisdiction. Interested traders should also thoroughly review their local financial regulators' guidelines to ensure compliance and seek expert advice if needed. 

Example of CFD Trades

To illustrate a practical scenario involving CFDs, consider the following hypothetical situation where a trader is bullish on Apple Inc.'s stock (AAPL) which is currently priced at $150 per share. 

Instead of purchasing individual shares through traditional means, the trader decides to enter into a long CFD contract with an online CFD provider since they expect a rising market in AAPL's stock price.

If the trader’s market prediction proves to be correct, and AAPL reaches $160 per share, the trader will earn $10 on each CFD share of AAPPL they purchased if they close out their position at that price. 

If AAPL's price had declined to $140 during this holding period, however, they would instead have experienced a loss of $10 multiplied by the number of CFD shares they bought if they decided to close the trade there.

Going Long vs. Going Short

One significant advantage of trading CFDs is the ability to capitalize freely on both upward and downward moves in an asset’s market price. This versatility arises because CFD contracts enable traders to go either 'long' or 'short,' depending on their market outlook.

Going long refers to taking a bullish stance where you would buy a CFD in anticipation of the underlying asset’s price appreciating over time. Conversely, going short involves adopting a bearish perspective where you would sell a CFD since you predict that the asset's value will depreciate in the future.

Irrespective of the market direction you anticipate, CFDs can facilitate you earning profits as long as you make accurate market forecasts. The added leverage you can also typically use with CFDs can boost your earning potential if your market forecast turns out to be correct, as well as your losses if you call the market wrong.

Benefits of CFD Contracts

Several key advantages distinguish CFDs from other forms of tradable assets. Some of the more notable benefits associated with trading CFD contracts are listed below:

Higher Leverage

One especially appealing aspect of CFD trading for many retail traders with limited capital is the increased leverage you can use when trading them compared to that available in conventional equities markets. 

For instance, standard U.S. equity purchases at conventional stockbrokers governed by Regulation T only allow a maximum leverage ratio of 2:1 which would require a minimum deposit of 50% of the total value position. 

In contrast, holding an equivalent CFD position with an online broker may involve putting only a fraction of that amount up as margin, since equity CFD leverage ratios can range from 5:1 to 50:1 depending on the broker. Such a reduced margin rate can help traders amplify their prospective gains, but it will also magnify losses if the market moves adversely.

No Shorting Rules or Borrowing Stock

Unlike the rules governing certain traditional equity markets, CFD providers generally impose no restrictions on short-selling activities for stock CFDs. 

As a result, traders can more readily do objective stock market research and establish bearish equity positions whenever they wish. This provides them with much greater flexibility and the ability to react promptly and profitably to bearish stock market conditions. 

Furthermore, since actual ownership of the underlying asset is not required, CFD traders do not experience common issues related to locating and borrowing shares for short stock sales.

Hedging Your Portfolio

Another compelling factor that argues for the use of CFDs involves their use in portfolio hedging strategies designed to safeguard existing portfolios against unforeseen market downturns. 

For example, if your stock portfolio consists mainly of high-quality stocks, you can short a relevant stock index CFD if you think the overall equity market might drop. Consider an investor who holds a sizable allocation of their portfolio in technology sector stocks. 

If they expect an impending stock market decline based on broader economic uncertainty, they could enter into opposing short CFD positions against their existing tech stock positions as a hedging strategy. In this case, any losses on their stocks should theoretically be offset by gains on their CFDs in case the expected market decline materializes. 

Similarly, when looking to hedge a portfolio of forex trading positions, you can transact an equal and offsetting amount of identical currency pair CFDs in the opposite direction to your present currency futures or spot positions.

Such CFD hedges serve to reduce the volatility of a portfolio’s overall value by managing risk and protecting it from losses from a market drop, although the investor or trader would also give up profits from a market rise.

No Day Trading Requirements

The regulators of certain stock exchanges, such as the SEC in the United States, have chosen to mandate strict and rather high minimum account balances before permitting stock traders to engage in day trading activities above a given activity threshold. 

In the U.S., traders who make more than three-day trades in five business days where the number of day trades is over 6% of total trades made during this period are considered pattern day traders. Traders identified as pattern day traders then need to maintain a minimum account balance of $25,000 and can use leverage of 4:1 instead of the usual 2:1 ratio. 

Online brokers who offer CFDs typically allow day trading with much lower account balances and higher leverage ratios. This allows traders of any experience level or trading account size to enjoy access to day trading activities.

Trading Opportunities in Various Markets

Using CFDs unlocks diverse trading possibilities that can span numerous asset classes depending on the online broker selected. 

Typical examples of underlying assets upon which CFDs are offered by online brokers include blue-chip equities, currency pairs, cryptocurrencies, precious metals, energy resources, agriculture products, and government bonds. 

In addition, most CFD platforms support stock market index CFDs providing synthetic exposures that track major market benchmarks such as the S&P 500 or FTSE 100.

Also, since CFD traders assume no actual position in the underlying asset when they are trading CFDs, they do not have to go through the trouble of the often-cumbersome delivery process for an asset. 

Risks of CFD Contracts

Despite the aforementioned attractive features, CFDs also carry inherent market and other risks that require careful consideration before taking a position in them. This section will explain some of the risks associated with using CFDs that require vigilance among traders using them. 

These risks fall under the general categories of market losses, liquidation risks, lack of liquidity and insufficient oversight which will be discussed further in the bullet points below.

Risk of Substantial Market Losses

Since CFDs can be more highly leveraged than positions in the underlying assets, even modest fluctuations in underlying asset prices can result in disproportionately large CFD position valuation swings. 

CFD traders should therefore exercise extreme caution when using high CFD leverage ratios given the speed with which initial margin deposits can evaporate under volatile trading conditions.

Risk of Liquidation

If an unfavorable market move occurs, unmonitored and highly leveraged CFD positions can quickly accumulate devastating losses. This can lead to premature position closures by your broker known as forced liquidations that then realize these losses. 

Depending on your broker, you may also face the possibility of getting a margin call and the requirement for depositing additional funds promptly to cover your losses.

Lack of Liquidity 

Despite the typical decent liquidity in the underlying market, illiquidity can be a concern when using CFDs since such contracts are generally transacted over the counter between a broker and their client. 

As a result, you can only return to that same broker to close out the CFD contract. Wide bid-ask spreads can sometimes emerge at a broker during fast markets that can hamper and increase the cost involved in your CFD trade entries and exits.

Lack of Regulation

Due to the rather ambiguous legal frameworks governing online trading activities, tax supervision of CFD trading activities can become an issue in jurisdictions where they are permitted. 

Substandard or even outright fraudulent online brokers can prey on unsuspecting victims. CFD traders therefore need to diligently verify an online broker’s regulatory credentials and check out their reputation with existing clients before opening a trading account.

Counterparty Risk

Counterparty risk materializes when the opposite party in a contract cannot fulfill their responsibilities and does not honor the financial contract. In CFD trades, a counterparty is vital for executing the over-the-counter transaction. Usually, CFD providers operating as online brokers play this counterparty role for CFD traders.

Since the CFD industry has lighter regulation compared to other markets, seeking a reliable and financially stable CFD provider is very important. If a counterparty defaults, redress through a regulator might be minimal.

Before creating and funding a CFD trading account with an online broker, be sure to investigate the broker carefully. Their reputation, track record, longevity, financial health, client reviews and trustworthiness can matter more than their formal regulatory status. Choose a reputable broker to minimize potential counterparty risks.

CFD Trading Costs

Before starting to trade CFDs in a live trading environment, make sure to familiarize yourself with the associated expenses that are likely to be encountered along the way. The main CFD trading costs include:

• Dealing Spread: Based on market conditions, a difference known as the dealing spread exists between buy and sell quotes provided by CFD suppliers. Persistent variations in the dealing spread can slowly decrease your trading earnings, so opting for online brokers with tight dealing spreads tends to enhance your chances of achieving better potential returns.
• Overnight Fees: Daily charges can occur for trading positions kept open beyond the market close or designated clearinghouse deadlines. These fees sometimes depend on interbank lending rates plus added markups. Some traders opt to minimize their overnight trading obligations to avoid such costs.
• Holding Costs: Extra financing expenses can stem from borrowed capital supplied by your online broker. Often stated as yearly percentages, these surcharges typically apply consistently during a transaction’s holding period.
• Commission Charges: Certain CFD providers charge flat transaction fees or commissions per trade, while others use a commission-free model where they earn their money by widening the dealing spread. Make sure to assess your overall commission costs when comparing online brokers and developing your CFD trading plan.
• Market Data Fees: Timely ticker updates aid in making better CFD trading decisions, although getting access to premium market data feeds is rarely free. Anticipate making recurring monthly payments for such information services or choose a CFD provider that offers complimentary access to them.

Compare CFD Brokers

When evaluating CFD service providers, make sure to consider important factors beyond just the dealing spread, including platform usability, customer support quality, educational content availability, research and market analysis facilities, and security measures. To help make choosing a suitable CFD broker easier, Benzinga has compiled the following table of CFD brokers you can check out to compare popular CFD brokers.

Are CFDs Right for You?

In conclusion, CFDs or Contracts for Differences offer a flexible way for online traders to operate in a wide range of financial markets without owning the underlying assets. Popular in many countries, yet banned in the U.S., CFDs present both advantages and disadvantages to traders. 

The main advantages of CFDs consist of having access to various markets, lower transaction costs, less regulation, higher leverage and the ability to use them when hedging. Their disadvantages include the risk of high potential losses from using leverage, counterparty risk and limited regulation. 

Furthermore, the various costs associated with using CFDs such as dealing spreads, overnight fees, holding costs, commission charges and market data fees, all need to be factored into your trading plan before you start trading CFDs in a live account. Overall, becoming well-informed and cautious about using excessive leverage can help increase your chances of success when trading CFDs. 

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