The Key Points to Know about Investing in Contracts for Difference
A contract for difference (CFD) is an investing tool stipulating that a buyer must pay the seller the difference between a specific asset’s current value and its value at the time the contract was made.
While this may sound complicated, CFDs are simply tools for driving profit based on price movements, not the underlying asset. With a CFD, the actual value of the asset is not important, only the change in pricing during the specified period. The CFD itself is merely a contract between client and broker that does not involve any exchange for stock, commodities, or futures.
Nevertheless, CFDs can be traded. This is what has driven their popularity as an investment instrument over the past decade or so.
How Contracts for Difference Work in the Real World
Investors can purchase CFDs through a broker. The CFD is an agreement between the broker and an investor to exchange the difference in value of a particular financial product, whether a security or a derivative, between when the contract opens and closes. Again, no physical goods or securities are delivered, and traders who work with CFDs never own the underlying assets.
Instead, they bet on how the price of those assets will change. With a CFD, traders can bet on the price moving up or down, depending on how the product is used and sold to other investors. When the price increases, traders can offer the holding for sale. If the trader expects the price to fall, an opening sell position can be placed.
Currently, CFD contracts are not allowed in the United States, but they can be purchased in the markets of many major trading countries, including Switzerland, Canada, the United Kingdom, Hong Kong, and the Netherlands, among others.
Trading CFDs typically involves a commission, as well as the spread, which is the difference in the purchase price and the current offer price. In some cases, there may also be a financing cost. Commission is not always charged and frequently is waived for commodities and forex pairs. However, commission is typical with stock-based CFDs. Usually, commission is charged for both the opening and closing positions. Interest is charged for people who hold long positions, meaning overnight or more in this case.
Why Traders May Choose CFDs
While CFDs come with significant risks, they also have advantages. For example, many CFD brokers offer products in different markets, which means traders have around-the-clock access to markets around the world. Brokers also generally have stops, limits, and contingent orders, which allow traders to be extremely strategic in the CFD markets.
Furthermore, brokers offer CFDs linked to stocks, indexes, currencies, sectors, and commodities, providing diverse opportunities for traders. There are no rules on shorting, because the trader never owns the underlying asset, and no requirements for minimum capital or caps on the number of trades. These limits usually apply to other types of trading.
Another advantage is that CFDs have higher leverage than more traditional approaches to trading. Leverage in the CFD market is regulated and now limited at around 3 percent, or 30-to-1 leverage, but could go up to 50 percent, or two-to-one leverage.
With higher leverage, traders need less capital to complete transactions and have the chance to secure larger returns. At the same time, this leverage could also magnify their losses and lead to significant financial burden if the trader bets incorrectly.
The Potential Downsides of Trading CFDs
CFDs have a number of advantages, but there are some serious potential downsides to understand. The biggest point to consider is the high level of risk involved with this type of trading. CFD trading moves lightning-fast and requires a lot of close attention. Traders need to maintain margins and will face some liquidity risks with these products. Brokers may end up closing a position if a trader is not able to cover reductions in value, which means the loss is locked in, no matter what happens to the underlying asset after that point.
As mentioned already, leverage risk exposes traders to larger potential losses. It’s also important to recognize that stop-loss limits do not protect against losses altogether, especially when the market closes or prices move dramatically. CFDs also come with execution risks related to lags in trades.
Furthermore, the fact that traders pay for both entries and exits can be a problem as this eliminates the profit from small moves. In other words, while CFDs shield traders from fees, regulations, commissions, and high capital requirements, the potential for winning big is curtailed by spread costs.
Traders should additionally understand that the CFD industry is not highly regulated and broker credibility is often based on reputation, rather than government oversight. Brokers should be investigated before any account is opened to avoid unnecessary risks. There are plenty of reliable brokers, of course, but this due diligence should not be skipped.