A gentle introduction to CFD

What is CFD?

A contract for difference, or CFD – a high-risk financial instrument, may sound ambiguous or even complicated while, in fact, there’s nothing very complicated about it. Imagine two parties, “buyer” and “seller.” They agree to enter a contract with the condition that the “buyer” will pay the “seller” the change in an agreed asset price.

For example, the “seller” has 10g of gold that currently costs £400. The “buyer” agrees to pay the difference between the current price of gold and the price of it at the time of contract closing. A few weeks after they both entered the contract, the global economy’s growth stops, and the price of gold increases substantially. The “seller’s” gold is now worth £550. The “buyer” pays the “seller” £150 – the difference between the price when the contract was opened and the price when the contact was closed. In the case of a price drop, the “buyer” would pay the “difference” to the seller. 

Where it’s used

CFD was created as a high-risk financial instrument in the early ’90s in London. Hedge Funds were early adopters, and it enabled them to access stock markets without physically owning them. At the end of the decade, CFDs became available to retail traders. Nowadays, hundreds of thousands of traders globally use CFDs to execute their trading strategies.  

Leveraged CFD broker accounts allow traders to access capital levels unlikely to be available when trading the underlying assets, such as stocks or gold. 

CFDs also make it easier to short sell assets that may not be available otherwise. However, individual brokers may have limitations on some asset classes. 

Traders can also leverage a higher number of simultaneous positions using stop-loss orders. We can see from the table below that short, intraday positions are the most popular among CFD traders.


5 minutes1 hour1 day1 week
Individual equities97%89%69%42%
Interest rate contracts94%70%36%17%
Commodities91%64%23%8%
FX84%50%13%4%
Equity indices78%41%11%3%

CFD Position length per asset class

Source: ECMA

Pros & Cons

Pros

Available leverage

One of the most significant advantages of CFDs is the leverage offered by online trading providers. A trader only needs to deposit a fraction of the overall amount available for trade execution. Traders can expect significantly higher returns than stock trading, where only the amount deposited can be spent buying stock.

Tax-efficient

CFD trading is not subject to stamp duty tax because the trader never owns the underlying asset. Any gains from trades would only be subject to capital gains tax.

Many asset types and classes

CFDs offer incredible freedom when it comes to the underlying assets. Traders can easily choose from commodities, such as silver or gold, stocks, or currencies. If you are knowledgeable in more than one asset class, most brokers will allow you to trade multiple asset classes in one portfolio.

Reasonable spread costs

Trading brokerage is a highly competitive industry, which means you, the end client, can enjoy low spread costs. Depending on the asset, it is common for broker firms to offer 1 pip (the last decimal place of a price quote) trade execution cost. 

Cons

Leverage to be used carefully

Leverage exposes traders to higher potential losses, and you should only use it with safeguards. Most brokers allow stop-loss, which helps the traders exit the trade if the price levels reach the maximum level the trader is willing to risk.

Need to understand the asset

While you may not need to be an expert in any of the underlying assets, it helps even if you have a basic understanding. For instance, if your underlying asset is the US-listed companies’ stocks, it’s worth knowing that the release of unemployment numbers can impact stock markets and their behaviour.  

Summary

Journalists often write about CFDs as a high-risk financial instrument that may not be as attractive to retail investors as some may like to portray it. However, that’s only one side of the coin. Any trade, no matter how big or small, carries a level of risk. The assets traded may change in value, and traders can find themselves on the losing side. Such situations are most common amongst traders who tend to “shoot from the hip.” 

For those traders who don’t just blindly walk into any trade but rather know what they want to achieve, take measured risks, and are willing to learn from their own mistakes, CFDs open doors to many profitable trading opportunities.

In addition to being a tax-friendly and low trading cost instrument, CFDs also offer various options, depending on the trader’s experience. More experienced traders may want to spice up their trading portfolio with multiple asset classes and higher leverage. At the same time, beginners can start with only a single asset, conservative stop-loss orders, and gradually build their experience towards more risky, yet much more profitable trading strategies.