A contract for difference (CFD) is a type of financial derivative, where the two counterparties agree to cash-settle the difference between the opening price and the closing price. CFDs do not involve any actual delivery of physical goods or securities.
For retail traders, their broker is typically also their counterpart in CFD trading. They do not have other traders as their counterparts.
CFDs are not exchange-traded and they are not standardized. It is therefore extra important that you check the terms and conditions of a CFD before you put any money on the line.
CFDs are available for a wide range of underlying assets and instruments, e.g. commodity prices, company shares, exchange-traded fund shares (ETF shares), futures contracts, and even indices.
Why are CFDs so popular among retail traders?
- CFDs make it easy to make trades that suit your budget and allow for proper risk management. Buying company shares can require a big investment. With CFDs, you decide how much to risk on each trade, and there are brokers that will offer CFDs at levels suitable even for micro-traders.
- CFDs make it easy to trade in either direction. If you think that a security is about to go down in price, you can use a suitable CFD to gain exposure instead of doing a more complex short-selling deal.
- Most brokers that offer CFD trading offer leverage CFD trading. This means that you can borrow money from your broker for your trading.
- CFDs are available for a wide range of underlying assets and instruments. You can even use them to speculate on indices or to gain exposure to cryptocurrencies without actually buying any cryptocurrency.
- The transaction costs associated with CFD trading tend to be low. Example: Investing in the stock market involves actually becoming the owner of company shares, which in turn usually involves commissions/transfer costs and – in some cases – a stamp duty or similar. With CFDs, you can gain exposure to a share price without actually buying, owning and
CFD trading basics
In essence, contracts for difference are used by traders to bet on whether the price of the underlying asset will rise or fall. If you expect the price to move up, you buy a CFD. If you expect the price to move down, you sell an opening position.
James thinks the price of Apple Inc shares will go up, so he buys a CFD based on this. His prediction is correct, and the price of Apple shares starts going up. To cash in on his investment and close the position, James offers his holding for sale. After the sale, the net difference between the purchase price and the sale price is his gain and will appear in his trading account.
James thinks the price of Amazon Inc will go down. Therefore, an opening sell position is placed by him. He is right in his prediction and the price of Amazon Inc drops. To close the position, James must purchase an offsetting trade. The difference is his gain and will appear in his trading account.
James wants to gain exposure to the movements of the wider U.S. stock market. He, therefore, seeks out a CFD based on the SPDR S&P 500. This is an exchange-traded fund (ETF) composed to track the S&P 500 stock index.
James buys a CFD based on 100 shares of the SPRD S&P 500. The price is $250 per share, so the total price is $25,000. James does not need to have $25,000 in his trading account to complete this deal, because his broker is offering him leverage. James only has to use $1,250 from his trading account (5% of the total deal) as he can borrow the rest from his broker.
A few weeks later, the SPRD S&P 500 is trading at $300 per share. James exists the position. $300 x 100 shares = $30,000. $30,000 minus the $25,000 is $5,000.
James has paid back his broker the $23,750 and Jame´s profit of $5,000 is now in his trading account.
Here are some tips for minimizing the risks of CFD trading:
- Start by understanding the risks involved in CFD trading and being realistic about your own risk tolerance and financial situation. This will help you to make informed decisions and avoid taking on more risk than you can handle.
- Use risk management tools, such as stop-loss orders, to limit potential losses. These can help to ensure that your losses are kept within a predetermined level, even if the market moves against you.
- Set appropriate position sizes based on the amount of capital that you are willing to risk. This will help to ensure that any potential losses are kept within a manageable level.
- Keep a close eye on the market and be prepared to adjust your positions or close them out if necessary. This will help to minimize your potential losses and protect your capital.
- Use a reputable and regulated broker that offers a range of tools and services to help you manage your risk. This will give you access to the information and support you need to make informed trading decisions.