CFDs are becoming a popular alternative for traders looking for short-term leveraged trading of stocks and other assets. In this expert guide we will teach you what a CFD is and how CFD trading works. We also list and compare all the regulated CFD brokers on the market, with detailed reviews for readers who want all the facts before signing up.
Top CFD Platforms
What Is a CFD?
A Contract For Difference (CFD) is a tradable product that mirrors an underlying asset. When trading CFDs, you’re making a contract to buy (or sell), on margin, and you collect (or pay) the difference when you close the position. Unlike buying a stock or futures contract, a CFD is a derivative, which means that you never actually own the underlying asset during the transaction. CFDs can be created to mirror almost any financial instrument or market, including individual equities, indexes, currency pairs, interest rate products or bonds. If it moves, and there is demand, you can be sure that there will be a CFD for it.
CFDs are generally not recommended for new traders. If you read the above paragraph and need to Google some of the terms used, it’s likely that you shouldn’t trade CFDs just yet. A solid understanding or leverage, margin, counterparty risk, and the complexity of derivative products is recommended. As a rule, you should only trade what you’re willing to lose, as CFD’s are volatile and you could be liable for extra losses. Set up a demo account and experiment, but make sure you do your research, understand the product and its ins and outs before you deposit real money into an account.
How Do You Trade A CFD?
The mechanics of trading CFD’s works much in the same way as buying or selling equities, futures or forex, except with a CFD you never actually own the underlying instrument. What you’re trading is the difference between the price when you first enter the trade and when you exit it. Hence the name, Contract For Difference. Most CFD providers also require that you cross the spread to enter or exit a position. Let’s run through a trade example for some clarity:
You want to BUY 100 “shares” in company XYZ, as you believe that the price is going up in the short term.
The current price is $10.55, the bid is $10.50 and the offer is $10.60.
- You click BUY, crossing the spread, and pay $10.60 for 100 “shares”.
- You’ve used $53 margin on your position (assuming a margin of 5%), instead of the $1050 + fees that you’d outlay if you bought the stock itself.
- The stock quickly moves to your target of $11, where you decide to sell.
- You click SELL, crossing the spread, and are filled at $10.95 on your 100 “shares”.
Congratulations! You made a profit of $35 (35c per “share” x 100) on your position.
As you can see, leverage is powerful. A $35 profit on a $53 margin (66%) is a far greater ROI than the 4-5% profit that you’d make buying the underlying, even if the total dollar amounts are a little less.
Here lies the attraction of leverage and CFDs. Of course, the opposite could also be possible. The equivalent move could wipe your CFD account of all of its capital (and more).
Why Trade CFDs?
As CFDs are leveraged products, they offer significant advantages and disadvantages over regular stocks or futures.
- Speculation: Because of the margin, CFDs are usually used by traders looking to trade short term or intraday moves. They can be very expensive to hold overnight, depending on the broker’s margin requirements and fee structure.
- Leverage: The amount of leverage available differs from broker to broker, depending on the product and market. The biggest advantage is the potential ROI a trader can achieve using CFD’s when compared to common stocks. As illustrated in the example above, you can easily make a 50%+ ROI on your margin used, which can be very attractive for speculators who are comfortable with risk.
- Margin: CFD brokers only require between 2% and 20% margin on your position, depending on the instrument and volatility. Much like forex, this allows you to trade larger size than you may otherwise be able to, or give you access to expensive stocks that you might not be able to trade. For example, if you want to buy 100 shares in Apple at $145, you’d need $14500 in your equity account, plus commissions. With a CFD broker, you may be able to trade the equivalent of 100 shares on a margin of $725, or 10 shares on $72.50. This opens up new markets and opportunities.
- Exposure to global markets: Most CFD providers offer a huge variety of markets. You could just as easily trade the German DAX as you could an Australian Equity. This can all be done on one account, without the need for expensive data or execution fees.
- Fees: Trading fees can add up pretty quickly, especially using retail brokers. There are no fee’s on CFD’s, only the spread (which represents its own challenge).
- Hedging: CFD’s offer those with equity portfolios the opportunity to quickly and cheaply hedge their long equity positions. Options can be a daunting and difficult to structure, especially if you’re using them to hedge positions. CFD’s give savvy traders a cheap alternative and a variety of hedging opportunities.
- Leverage: This is a double edge sword. While buying the equivalent of 100 shares in Apple is far cheaper using CFD’s, you’re exposing yourself to significant risk by doing so. A small move in the underlying can wipe out the value of your position or more, leaving you in the red with your broker.
- Crossing the spread: Entering or exiting a CFD position requires you to cross the spread. There’s no limit orders. This means that you’re always paying a premium to enter or exit a position. This is the price paid for access to margin. While this may seem insignificant, paying the spread can add up to a fair amount of money, especially if you’re an active trader. It also makes some strategies very difficult to execute (e.g. scalping).
- Betting against your broker: A CFD is a contract with your broker. They profit if you lose. This opens up many conflict of interest questions. It’s very important to research your broker, check if they’re regulated (many are not), and read online reviews. Get in touch with them directly if you have questions before depositing any money in the account.
When trading CFD’s your making a contract with your broker regarding the future movement of a financial instrument. Unlike trading an underlying, the counter-party to your trade is your broker itself. As you can imagine, this raises a myriad of conflict of interest issues, and regulators continue to try and find an acceptable balance between protecting customers from predatory practices and allowing traders the freedom to trade what they wish.
The skeptic could argue that trading CFD’s with your broker is like gambling at a casino. It’s in the casino’s best interest that you’re a happy, smiling customer…so they can ultimately take as much money as they can from you.
The believer would argue that it’s in a CFD broker interest to get longevity from clients, and that they make enough money from spreads and volume that there’s no incentive to do wrong by their customers. Shady practices would be reported to regulators, which would ultimately hurt their business and profitability.
The takeaway is that traders need to do their research on CFD brokers and regulation in their country. A good place to start is our list of recommended brokers.