When trading on a wide range of financial markets, you have definitely heard about the term CFD at least once. Ever wonder what the abbreviation is for “CFD” and which benefits it can give investors? Let’s find out about CFD trading in this article.
What Does CFD Stand For?
Short for a Contract For Difference, the financial term CFD refers to an agreement between two parties denominated as “buyers” and “sellers”. Accordingly, that contract officially states that a buyer has to pay a seller the difference between the current price of a financial asset and its value at the due date predetermined in the contract. In the case of the negative difference, the buyer’s account would be credited.
What are CFDs? The Definition of CFDs
Being initially developed in London within the early 1990s, CFDs give investors a good chance to earn profits from the market movement without owning the physical assets.
Traditionally, financial instruments are directly bought and sold in exchanges and these transactions often entail cash. For example, in conventional foreign currency trading, an individual will use the euro to buy the US dollar, or conversely, sell the US dollar to own the euro. This requires the person to possess the underlying asset before they conduct any trades.
However, many investors now are not concerned about whether or not they deliver or take delivery of physical assets because their main aim is to make money from the price fluctuation. Accordingly, retail traders will enter into a contract with brokerages to open CFD accounts which provide them greater flexibility and exposure to financial markets without requiring actual assets.
Unlike traditional trading, CFD trading is merely conducted over-the-counter (OTC) and therefore requires investors to open a trading account with brokerage companies before they start trading in certain timeframes. Therefore, when individuals engage in financial markets, especially forex, they often participate in CFD trading.
When opening a position, speculators who expect the price of assets to increase will open a long position to buy the CFD. On the contrary, if they predict those assets will experience a downward trend, they will go short (sell) assets. The difference between the selling and buying prices represents a gain or loss from a transaction.
CFDs themselves are not futures contracts though they support speculators to make money from the price moves of futures. This is simply because they determine no expiration date and preset price. After investors close their position in a proper time, the difference in the value of currency pairs will be credited or debited to their accounts.
Assets Traded on CFDs
CFD trading is considered a particular type of derivative trading and mostly used to hedge or speculate on plenty of financial instruments such as currencies, stocks, bonds or precious metals. However, the number of those assets are limited in a trading platform of brokers. More particularly, despite the total of 154 currencies from over 200 countries which can form thousands of pairs, normally, only approximately 60 currency pairs are traded; similarly, about 300 stocks are often exchanged whilst more than 43,000 domestic companies are publicly listed on the stock exchange, according to the World Federation of Exchanges.
The Pricing of CFD Products
Underlying assets in CFDs trading are differently priced out by their providers, commonly known as market makers. Nowadays, most CFD brokerages are not purely a mediator between clients and other market makers. Instead, they can also act as dealers and counterparties to a client’s transactions, therefore placing slightly different prices for financial assets they provide.
The Legality of CFD Trading
Is CFD trading legal? The answer is yes, but the legitimacy of CFD trading – in other words, the validity of a broker’s operations – varies by country. Credible brokerages will be supervised under the strict regulation of international and domestic organisations to avoid money laundering. Therefore, a careful search for legitimate brokers is essential for investors to secure their finance and transactions.
However, CFD trading is prohibited in the United States. This results from concerns of American regulators about the high probability of big losses arising from using leverage in CFD trading.
CFD Trading Meaning
CFD trading has increasingly become widespread because of its potential benefits. However, it also comes with unanticipated shortcomings; without good preparation, investors can easily make mistakes in trading, which results in a big loss.
Advantages of CFD Trading
No Ownership of Physical Assets
As already mentioned, the core of CFD trading is allowing investors to bet on the change in the value of underlying assets without owning them. Fortunately, “borrowing” assets from brokers involve no incurred interest rate.
Leverage (Margin Trading)
Compared to standard exchanges, the CFD market offers higher leverage and therefore a lower margin. Using leverage allows investors to augment their investment multiple times, even when they start small. Meanwhile, a margin is an amount of the initial outlay that should be set aside from the trading capital to keep an investor’s positions always open.
Margin is inversely proportional to leverage. Normally, the margin in CFD trading can range from 2% to 20%, equivalent to the leverage ratio of 1:50 to 1:5 respectively. Especially, most brokers enable their customers to magnify their investment up to 200 or 500 times in currency trading.
In other words, brokerage companies “lend” speculators a large amount without incurred interest rates. If they have a proper trading strategy and decent fundamental as well as technical analysis of price action, they will receive much higher returns.
Ease of Access
On the OTC market, trading CFDs is easily executed in trading platforms, commonly MetaTrader 4 and 5. The platform is available in different versions for desktops, websites, iOS and Android operating systems of mobile devices. This facilitates your access whenever and wherever possible as long as your gadgets are well-connected with the Internet.
Low capital requirements
No specific legislation stipulates how much a trader should invest in CFD trading as the minimum. This, coupled with using leverage, allows the trader to fund his or her account with a modest amount. Thereby, you can even start at $100. Having said that, speculators are advised to start with a higher amount for more flexibility.
Small Contract Size
Investors can open a small position if they want a more secure trade. Accordingly, they may even buy one share CFD or buy a nano lot (100 units) of currency pairs as long as their brokers allow them to do so.
Moreover, traders may easily trade any financial instruments already provided by brokers without restrictions on jurisdictional boundaries.
No expiration date
As previously stated, CFDs don’t specify due dates of transactions. Depending on different trading strategies (e.g. day trading, swing or position trading), investors can independently close their positions at any time.
Disadvantages of CFD Trading
Spreads and Other Fees
Despite no interest rates required when brokerages lend clients financial assets for trading, investors have to pay spreads and other relevant fees. Spreads are transaction costs paid to brokers. By definition, a spread is widely understood as the gap between the bid (buy) and ask (sell) prices of underlying assets. This type of expense will be deducted from a trader’s account when he or she opens and then closes a position. Of all financial markets, forex has the smallest spreads which are measured in pips (a pip equals 0.0001). However, some brokers may allow their customers to open raw spread accounts that require no or a tighter spread.
Further, speculators can bear other fees incurred from a broker’s services, for example, commissions for deposits and withdrawals. In addition, similar to traditional trading, those wishing to keep positions overnight will be charged overnight financing costs, also called rollover rates or swap fees.
Risk is unavoidable in CFD tradings. Therefore, before jumping into any investment, traders are encouraged to learn about risk management first. Thereby, CFD traders should take account of some risks as follows:
Market risk originates from utilising leverage to increase the possibility of higher returns. Leverage is a double-edged sword; although it can give you larger trading capital to open bigger positions with the hope of higher profits, it can make you lose more if the price of traded assets goes unfavourably with your desire.
The higher leverage ratio results in a smaller margin kept aside in your account. This means when the price goes in an unexpected direction, not only do you suffer a big loss, but your account balance is quickly burnt as well. Consequently, your trading account will receive the margin call. If it’s not immediately funded to cover a loss of margin, brokers, at this time, can close all positions without your permission. This is called liquidation risk.
Counterparty risk refers to the inability of the counterparty to fulfil financial obligations of a contract. Accordingly, CFD traders will sustain massive losses and receive no profits from CFD trading even when the price move is in a positive trend. In other words, counterparty risk is closely associated with the credibility of brokers. Having said that, nothing can guarantee their financial stability in times of crisis, typically in the 2008 economic downturn.
The Example of CFD Trading
EUR/USD is priced at 1.22452/ 1.22471, of which the ask price is 1.22452 and the bid price is 1.22471. Accordingly, the bid-ask spread of 1.9 pips is assumed to the mere transaction cost paid to a broker. You decide to buy 10,000 euros as you predict the exchange rate of the pair will appreciate.
Your trading account is denominated in the US dollar. Besides, the broker requires a margin rate of 5%, hence your position margin will be US$612.355 (= 5% x [€10,000 x 1.22471]). There are two scenarios as follows:
You’re correct about the price movement. Accordingly, the value of EUR/USD goes up by 20 pips to 1.22671. Your profit will be [€10,000 x 1.22671] – [€10,000 x 1.22471] = US$20.
In other words, when trading a mini lot (10,000 units of euros), a one-pip move is valued at US$1. Therefore, a 20-pip profit is equivalent to US$20.
Unfortunately, the market moves against your favour. However, you previously placed a stop-loss order at 1.22371 and accepted the maximum loss of 10 pips. When the position is closed at that price, you will lose US$10.