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What is a CFD - Contract for Difference

If you've opened an account with a trading broker, you've probably stumbled upon the term CFD. But What is it exactly? CFD, or contract for difference, is a financial derivative that allows you to trade way beyond your current account balance. Thus, you can increase your profits and losses, which happens more often than not.

What are contracts for difference?

A contract for differences (CFD) is a financial contract between the buyer and the seller, where the difference between the open and closing trades is cash-settled. CFDs facilitate trading the price movement of stocks, indices, ETFs, commodity futures, etc. It allows the investors to enjoy the benefits and risks of security without its physical delivery. Many brokers, or investment apps, also provide trading in Bitcoin CFDs. In addition, CFDs allow leverage to the investors, who put only a small amount of the trade with their broker.

The invention of CFDs can be attributed to the efforts of Brian Keelan and Jon Wood in the early 1990s. They developed CFDs to use them in London as an equity swap traded on margin. Hedge funds and institutional investors initially used the CFDs to gain stock exposure on the London Stock Exchange due to its small margin requirement and stamp duty avoidance because of no physical transfer of shares. Retail traders, however, started using them in the late 1990s. GNI (known initially as Gerrard & National Intercommodities) was the first company to introduce it through GNI Touch, its CFD trading service. MF Global later acquired it.

IG Markets and CMC Markets popularized it in 2000 and expanded it overseas, starting with Australia in July 2002. CFD trading is available in Austria, Canada, Australia, France, Germany, Cyprus, Italy, Ireland, Israel, Japan, United Kingdom, etc. However, the Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission prohibit CFDs from been listed on regulated exchanges in the USA due to high-risk involvement. The Securities and Futures Commission of Hong Kong, too, forbids trading CFDs. In addition, the European Securities and Markets Authority (ESMA) issued a warning against the sale of speculative products, including CFDs sale in 2016.

In Europe, any provider can offer all the products under the markets in financial instruments directive Directive(MiFID) 2004/39/EC to all member countries. However, the Cyprus financial regulator, CySEC, limited the maximum leverage on CFDs to 50:1 and prohibited paying bonuses as sales incentives in November 2016. 

The UK FCA issued similar restrictions on December 6, 2016. It further limited maximum leverage to 30:1 for CFDs and CFD-like options in 2019. 

BaFin, the German regulator, prohibited additional payments when a client incurred losses following the ESMA warning. Autorité des marchés, the French regulator banned all advertising of CFDs.       

What is CFD trading?

CFD trading involves exchanging the difference in the asset price between opening the trade and closing it. Thus, leverage and margin are the primary characteristics of CFD trading. 

It offers leverage which means you, as a trader, can open a large position without committing to the total trade cost. In addition, you have to offer a deposit margin to open a new position, representing only a fraction of the total amount. Finally, a maintenance margin is also required when the trade incurs losses that the deposit margin and any additional funds cannot cover, thus, resulting in a margin call from the broker, which, if not met, may force the broker to close the position.

CFD prices are quoted in the buy and sell price. Sell prices are lower, and buy prices are higher than the current market price. The difference between them is also known as the spread. Most of the time, the cost of CFD trading is covered in the spread, but the charge is commission-based while trading CFD stocks.

The CFDs are traded in standardized contracts, which depend upon the underlying asset. Further, they don't have an expiry time. The profit or loss is calculated by multiplying the total number of contracts by the value of each contract. The resultant figure is then multiplied with the difference between the opening and closing price of the underlying.

For example, you buy 50 FTSE 100 Index CFD contracts valued at £2 each, when the buy price is 7,025, and sell it at 7,030. 

Thus, profit= (50*2)*(7,030-7,025)= £500.

The broker also charges the overnight funding charge if the daily CFD position remains open after the daily cut-off time.

Risks of CFD trading

CFD trading is subject to different types of risk such as:

  • Market Risk - The risk and rewards for CFDs trading is greater since you trade on leverage. The FCA of the UK estimates the average loss per client amounts to £2,200. The loss can be much more than the initial deposit by the traders if the market moves against their position. 
  • Liquidation Risk - The broker calls for a margin call, asking the traders to deposit additional sums if the price moves against the open CFD position. If the trader fails to meet the margin call, the broker may liquidate the position at a loss. 
  • Counterparty Risk - In OTC CFDs, there is also a counterparty risk associated with the counterparty's solvency. The CFD is of little or no value if the counterparty fails in its financial obligations. 

The risks of CFD trading are mainly due to its inherent disadvantages such as:

  • The losses are bigger due to leverage.
  • The market's extreme volatility results in wide spreads by the broker.
  • The losing position of the traders can invite margin calls from the broker.

The Saferinvestor study of 2021 showed an average client loss in trading CFDs was 74.38%. eToro reveals that 67% of its retail investors lose money trading CFDs. Similarly, the percentage of retailers losing money while trading CFDs with brokers like Plus500, CMC Markets, Pepperstone, Core Spreads, Libertex is 72%, 70%, 75.4%,71.2%, and 83%, respectively.  

Conclusion

CFDs involve a high-risk element, which can often lead to amplified losses due to the leverages offered. Further, retail traders losing money while trading CFDs with different CFD trading platforms is more than 70%. Thus, trading CFDs demands expert trading knowledge and exceptional risk management skills of the traders.

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