Contents:
What Is a Contract for Differences (CFD)?
How CFDs Work
Which Countries can you Trade CFDs?
Underdtanding the Expenses Involved in CFD Trading
Advantages & Disadvantages
Example of a Losing Trade
FAQs
What Is a Contract for Differences (CFD)?
A Contract for Differences (CFD) is a financial derivative that allows traders to speculate on the price movement of an underlying asset without owning the asset itself. Think of it as a wager between you and your broker about where an asset like a stock, commodity, or currency will go. If you predict correctly, you make money; if not, you lose
CFD trading is a sophisticated tactic best suited for traders with a high level of expertise. In this approach, there’s no actual exchange of physical goods or ownership of the underlying asset. Rather, the trader earns money based on the asset’s price fluctuations. For instance, instead of buying or selling actual gold, one can merely forecast if its value will rise or fall.
In a nutshell, CFDs provide an avenue for speculating on the future value of assets or securities. You can place wagers on price movement in either direction. If you’re holding a CFD and the asset’s price ascends, you can opt to sell your stake.
At that point, the difference between the original buying price and the selling price is calculated. This difference, representing the earnings from the trade, is then credited to the trader’s brokerage account.
Conversely, if a trader anticipates a downward trend in the asset’s value, they can initiate a sell position to open the trade. To exit the trade, they’ll need to execute an opposite buy trade. Subsequently, the calculated net loss is settled in cash and reflected in their account.
Which Countries can you Trade CFDs?
United States: CFD trading is prohibited, as enforced by the U.S. Securities and Exchange Commission (SEC). However, nonresidents may engage in CFD trades.
Brazil: Banned
United Kingdom: Permitted
Australia: Permitted
Germany: Permitted
Switzerland: Permitted
Singapore: Permitted
Spain: Permitted
France: Permitted
South Africa: Permitted
Canada: Permitted
New Zealand: Permitted
Sweden: Permitted
Norway: Permitted
Italy: Permitted
Thailand: Permitted
Belgium: Permitted
Denmark: Permitted
Netherlands: Permitted
Hong Kong: Allowed within the special administrative region
Understanding the Expenses Involved in CFD Trading
CFD trading incurs various costs like the spread, financing fees, and possibly commissions. The spread is the price gap between buying (bid price) and selling (ask price) at the moment you initiate the trade.
While trading forex pairs and commodities usually doesn’t involve commissions, dealing in stocks often does. For instance, let’s consider eTrade, an international financial services firm, which levies a starting commission rate of 0.09%, or $0.03 per share, for shares listed in the U.S. and Canada. Keep in mind that both opening and closing the trade will each incur a separate commission fee.
Financing Fees
Financing fees may apply when you hold a long position overnight, essentially because you’re borrowing capital from the provider to maintain your position. In such scenarios, traders will typically pay an interest fee for each day the position remains open.
An Illustrative Example
Let’s say a trader decides to invest in Adobe stock through CFDs with an investment of £12,000. The current share price for Adobe stands at £30. The trader anticipates that the stock will go up to £32. The bid-ask spread is £32–£30.
Upon opening the position, the trader faces a 0.09% commission fee. The trader purchases 400 contracts at £30 per share, bringing the total investment to £12,000. After 20 days, the stock price does climb to £32. The initial value of the trade was £12,000, but it now amounts to £12,800.
Here’s how the trader’s earnings look before accounting for any additional charges:
Profit before charges = £12,800 – £12,000 = £800
Let’s assume the commission costs £11 to enter and another £11 to exit the position. Also, let’s say the interest fee is 8%, which would be levied on each of the 20 days the position remains open (400 × £30 × 0.08/365 = £2.63. Since the position remains open for 20 days, this amounts to 20 × £2.63 = £52.60).
In summary, the trader’s net profit would be:
£800 (Gross Profit) – £11 (Initial Commission) – £52.60 (Financing Fees) – £11 (Closing Commission) = £725.40 (Net Profit)
Understanding the different types of costs involved in CFD trading is crucial for both novice and seasoned traders alike.
Advantages of CFD Trading
Increased Leverage: CFDs offer the advantage of higher leverage compared to traditional forms of trading. Regulatory guidelines now cap leverage, which used to be as high as 50:1 (2% margin requirement) but is generally limited to a scale of 30:1 to 2:1 (3% to 50% margin). This allows traders to commit less capital upfront, potentially amplifying gains. However, it’s essential to note that higher leverage can also accentuate losses.
Example of Advantage: Imagine you have £1,000 to invest. With 30:1 leverage, you can take a position worth £30,000. If the asset value goes up by 10%, your profit would be £3,000, effectively tripling your initial investment. But caution is advised; if the market moves against you, the losses would be equally magnified.
One-Stop Access to Global Markets: A single CFD platform often provides entry to a variety of international markets. This is beneficial for investors who want 24/7 trading capabilities.
No Constraints on Shorting or Borrowing: CFDs are exempt from regulations that prevent short-selling or that impose complicated margin requirements. This is mainly because the trader never actually owns the asset.
Variety of Order Types Without Fees: Many CFD brokers offer the same types of orders as traditional brokers, like stop and limit orders. Though some might charge for guaranteed stops, there are usually no separate commission fees.
No Day Trading Restrictions: In contrast to some markets that have day trading rules and minimum capital requirements, CFD trading is more accessible, often requiring a smaller initial deposit.
Diverse Trading Options: From stocks and currencies to commodities, the range of CFDs you can trade is vast, providing numerous opportunities for traders.
Disadvantages of CFD Trading
Spread Costs: One downside is the necessity to pay the spread when entering and exiting positions, which can erode smaller gains and add to losses.
Example of Disadvantage: If you are trading an asset with a spread of 3 points and you enter and exit the trade, you’ll essentially start 6 points down. This means small gains can be wiped out, and losses could be slightly worse than in traditional trading.
Lack of Stringent Regulation: The CFD industry is less regulated than traditional markets. Thus, due diligence is crucial when selecting a CFD broker.
Assorted Risks: CFD trading can be volatile and require constant monitoring. There are various risks involved, such as liquidity risks and the need to maintain margin levels. Failing to do so can result in the closure of your position by the provider, incurring losses irrespective of any subsequent asset recovery.
By understanding both the pros and cons, you can make an informed decision about whether CFD trading is suitable for you.
Example of a Losing Trade
The Setup
Initial Deposit: You start with an initial deposit of $1,000 in your CFD trading account.
Asset Chosen: You decide to trade CFDs on Company XYZ, which is currently priced at $50 per share.
Leverage: The broker offers you a leverage of 50:1, allowing you to take a position worth $50,000 (i.e., $1,000 * 50).
The Trade
Opening the Position: You “buy” 1,000 CFD contracts of Company XYZ at $50 per share, costing you a total of $50,000. Thanks to the 50:1 leverage, your initial margin requirement is only $1,000.
Commission: Let’s assume the broker charges a 0.1% commission on the trade. That means you pay $50 initially ($50,000 * 0.001).
Market Movement
Unexpected News: Company XYZ announces poor quarterly earnings, and the share price drops by 20% almost instantly to $40 per share.
New Position Value: Your 1,000 CFD contracts are now worth $40,000 (1,000 * $40).
Closing the Position
Trade Loss: Your loss is $10,000 ($50,000 initial value – $40,000 current value).
Additional Commission: You pay another 0.1% commission for closing the trade, another $40 ($40,000 * 0.001).
Total Loss: Your total loss comes to $10,000 (Trade Loss) + $50 (Initial Commission) + $40 (Closing Commission) = $10,090.
The Outcome
Exceeding the Initial Deposit: Your total loss of $10,090 exceeds your initial deposit of $1,000.
Margin Call: Because your position has fallen so dramatically, your broker issues a margin call, requiring you to deposit additional funds to cover the loss.
Net Result: You’ve not only lost your initial deposit but also owe the broker $9,090 more to square off the position.
This example shows the high risk associated with leveraged CFD trading, emphasizing the need for careful risk management strategies such as stop-loss orders. Even then, substantial losses are possible, and it’s crucial to fully understand the risks involved before engaging in CFD trading.
FAQs
1. What is a Contract for Difference (CFD)?
A Contract for Difference, or CFD, is a financial derivative that allows you to speculate on the price movements of underlying assets, such as stocks, commodities, or currencies, without owning them. Essentially, you’re entering into a contract with a broker to exchange the difference in value of the asset from when the contract is opened to when it is closed.
2. How Do Leverage and Margin Work in CFD Trading?
Leverage is a feature that allows you to control a large position in an asset with a relatively small amount of capital. The margin is the initial deposit required to open a leveraged position. For example, with a 50:1 leverage, you could control a $50,000 position with just $1,000. However, leverage can magnify both profits and losses, making it important to use risk management strategies.
3. What Are the Costs Involved in CFD Trading?
The primary costs in CFD trading are the spread, commission, and overnight financing charges (also known as swap rates). The spread is the difference between the buying and selling price of the asset. A commission is sometimes charged for trading assets like shares. Overnight financing is applied when a position is kept open past the end of the trading day.
4. Can You Short Sell Using CFDs?
Yes, one of the advantages of CFD trading is the ability to profit from falling markets. You can “sell” (or “short”) a CFD if you believe the underlying asset’s value will decrease. If the asset’s price falls, you can buy it back at a lower price, making a profit from the price difference.
5. Are CFDs Available for Trading in All Countries?
No, CFD trading is not permitted in every country. For example, it is not allowed in the United States due to regulatory restrictions. However, it is accessible in many other countries like the United Kingdom, Australia, Germany, and Singapore among others.
6. What Risks Are Involved in CFD Trading?
CFD trading comes with several risks including market risk, leverage risk, and liquidity risk. Market risk involves the potential for the asset’s price to move against your position. Leverage risk arises from the use of borrowed capital, which can amplify losses. Liquidity risk pertains to the ease with which the asset can be bought or sold without causing significant impact on its price. Due to these risks, it’s crucial to have effective risk management strategies in place.
Understanding these basic elements can help you make more informed decisions in the complex world of CFD trading. Always remember to consult with financial advisors and do your own research before engaging in this type of investment.
