CFD – Contracts For Difference
What is a contract for difference (CFD)?
CFD is an agreement between the buyer and the seller, which obliges the seller to pay the buyer a difference between the asset’s current value and the asset’s value at the time of contract closure. If the buyer went long and the difference in price is negative, then the buyer pays the seller and vice versa. CFDs are financial derivatives that allow us to speculate on the price development of the underlying asset without the need to own the underlying asset. It is a so-called derivative that covers a wide variety of financial instruments traded on both stock exchanges and OTC markets around the world. The term “financial derivative” is based on the meaning of the English word “derive”. It is, therefore, a kind of derivative of a particular asset. In our case, it is a derivative of the selected financial instrument traded on one of the world exchanges. We also call this financial instrument an underlying asset, which can be a stock, index, commodity, currency pair, cryptocurrency, etc. The price of derivatives is fully dependent on the price of the underlying asset.
History and pros/cons of CFDs
For CFDs, it is 1990 when the first derivative was created by the famous London broker Smith New Court. It was a financial product that bore all the benefits of trading stocks without the need for their physical possession while minimizing their disadvantages. Compared to shares, it was several times cheaper and allowed to take short positions without the need for the previous borrowing of shares. At the end of 1990, a company called GNI was allowed to trade CFD contracts directly on the London Stock Exchange by forwarding instructions over the Internet.
CFD trading is very popular and is offered by many brokerage companies. CFDs are traded to profit from price differences between sales and purchases. CFDs are, therefore, among the financial derivatives that are always linked to their subject underlying financial asset. The specific type of underlying asset is levied by each intermediary company (brokers, banks, etc.) according to its capabilities. This is often the currency pair, stocks, equity indices, commodities, bonds, interest rates, etc., traded on a world exchange.
The main con is that there are no standard contract terms for CFDs, each provider can use its own, but the substantial part usually remains unchanged. Lack of regulation is the main reason why CFD trading is banned in the United States.
However, as we are not a broker, even traders from the US can trade CFDs with FTMO. CFD thus constitutes a contractual arrangement between the seller’s party and the buyer’s party, as we already mentioned.
Long term holdings of CFDs
Holding open CFDs for a longer period is possible, but it should be remembered that even though CFDs do not expire, the trader can be charged swaps for overnight holding. The size of a swap is based on the interest rates of central banks of the countries whose currencies we trade. The larger the difference in rates, the larger the swap. A swap is positive when a long position is held in the currency with the higher interest rate, while it is negative when the trader is in a short position on the currency with the higher interest rate. Thus, a swap differs for different currency pairs. Its size also depends on the broker (liquidity provider).
The norm is that swap charging place at 10 PM British time, but this differs from broker to broker, and it is always necessary to verify the specific terms of your account.
The main reasons to trade CFDs
CFDs are available with many brokers who also provide classic investment products. Since you have never owned an underlying asset for CFD contracts, you can trade markets that are otherwise non-negotiable for a retail trader, such as indexes. With CFD contracts, you can benefit from a rising price and the price declines. Most stock CFDs can also be shorted, and you don’t need to borrow stocks as you normally would for traditional investments. CFD trading can be made extremely fast. It depends on the broker’s execution time. You should know that a good trading platform has a live market data feed, and various automated trading systems can work their logic on these data changes immediately.
CFD contracts are traded with leverage, so you don’t need high initial capital to speculate on short-term volatility fluctuations. This means that you only need a fraction of the position value to open the order, and you can use some of your capital for other purposes, such as scalping other CFDs. However, you should remember that while leverage reduces the margin needed to open a trade, profits, if any, may be significantly higher than when trading without leverage. Obviously, the same applies to losses too. You should also remember that even if you do not physically buy the underlying asset, you are exposed to the underlying markets, and there are different risks involved.
CFD vs Futures
Let’s say that we want to trade the very popular German DAX on futures markets. Due to the large volatility, the intra-day margin is around €13,000 per contract (dates from 2018). The intra-day margin is the reserve deposit on the account for opening the trade. If we hold the position overnight, the margin reaches far beyond €21,000.
How about commissions?
The commissions for trading CFDs used to be greater than on Futures, but today the situation is unclear. For example, FTMO clients can access CFD contracts on stock indices, crypto or futures with zero commission. However, the truth is that trading Futures is still much more difficult financially because of paying for the data feed and platforms.
It is important to consider that most retail traders don’t have €21,000 to spare for trading DAX from the beginning. This is where the best advantage of CFD comes in place instead of the futures. Dividing the positions enables us to trade DAX with much smaller capital requirements. From the risk-taking perspective, having the possibility to trade DAX through CFD is yet more significant.
In the last column of the table above, we can see the DAX position sized 0.2 lots traded through CFD. The beauty of CFDs is in the possibility of working with multi-contracts while having a small capital. If we were to trade the highest position of 0.2 lots while having two different profit targets, CFD would allow us to enter twice by 0.1 lots each and set the required parameters separately.
Finally, it’s important to mention that trading the futures indexes through CFDs isn’t suitable for all markets and this is due to the associated costs. This is predominantly for short-term traders who target smaller profits. Talking about the DAX index, the ratio between the spread and the daily range is actually very good. This makes DAX an ideal market to be traded through the CFD. Other optimal markets for day trading CFDs would be Nasdaq or gold.