What is CFD trading?

 

Contracts for Difference (CFD) are derivative products that are largely traded over-the-counter (OTC). They let traders speculate on the movement of the market without actually owning the underlying asset. The idea is to enter the trade low and get out high, just as one would with an equity trade. CFDs are also shortable. They have plenty of advantages, but there are, of course, a few disadvantages. First, let’s explore what exactly a CFD is.

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History and Usage

The CFD is as literal as its name: it is a contract, between the trader and the broker, that awards the difference in the entry and exit price points of the underlying. The instrument was originally developed in the UK to skirt the UK stamp duty tax, because there were no shares changing hands. Of course, the instrument originally wasn’t very useful outside the UK, because the tax didn’t apply outside the UK.

Some time later, the true advantage of CFDs were discovered: leverage. Margin and leverage are meant to amplify profits, because it requires less capital to enter bigger trades. When owning equity, margin requirements can be quite high, especially on riskier stocks. The level of initial margin may be as high as 70% on regular stocks, and some stocks require 100% (in other words, they are not marginable). Most brokers require at least 50%, even for highly stable stocks. That means a trader with $10,000 could make a $20,000 trade, but that’s the upper limit.

Since CFDs are not governed by the same rules as their underlying, they may require as little as 1% equity – that means a trader with $1,000 could enter a trade worth $100,000. The trader never receives ownership of the $100,000 worth of shares, but the profit/loss is reflected as if $100,000 worth of shares are under the trader’s control. This is what margin does. There are gold CFDs with equity requirements under 1%!

Aside from speculating, CFDs are quite useful for hedging. If you know what options are, you understand that derivatives can be very helpful in hedging. If you have a long-term position on a stock and intend to keep it, but there are major fluctuations in the stock due to news or macroeconomic factors, you can take the opposite position with very little capital (remember our 100:1 leverage possibilities) with CFDs. So, be aware that CFDs are not meant solely for speculating.

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Pros and Cons

Advantages

What kind of asset classes comprise the underlyings for CFDs? There are plenty. Some of the big brokers offer CFDs on FX, indices, equity, commodities (metals, energy, others), options, sectors, and interest rates. They can even represent the outcome of economic data or political events. Brokers have advertised upwards of 10,000 underlying assets that can be traded with CFDs.

For diversification purposes, they are a lot like ETFs in their breadth of underlying assets. CFDs can represent baskets of shares or currencies, which can be difficult for an individual to maintain on their own – not to mention the transaction costs and large sums of capital required to hold a portfolio that mirrors a major index like the S&P500. The transaction costs on maintaining a portfolio mirroring the S&P500 are prohibitive for individuals, let alone the gigantic capital requirement. The Nikkei or DAX are similarly difficult to maintain. Perhaps more importantly for foreign plays, though, is that making money from foreign markets is simplified, too, because you never own the underlying.

In fact, that is one of the biggest advantages of CFDs. The original intention of saving the UK stamp duty tax succeeded because the underlying never changed hands. The same goes for foreign investment – it can be difficult or even impossible to acquire foreign shares if you don’t have the right legal setup, but, with CFDs, you can still easily gain exposure to foreign markets or hedge your domestic portfolio against foreign movements.

Another advantage is the completely free open and close times and price points. Unlike options, there is no expiry, so you don’t have to deal with time decay. Some brokers do offer forwards-style CFDs, which have an expiry date. However, most of them do not have specific times when you must exit the trade. That opens up a lot more opportunity, because you can hold on longer or close early without worrying about time decay losses.

Continuing with time, there is also 24-hour support. Even if the underlying’s market is closed, many brokers still allow you to place trades (note the spreads may widen, just as they do for other asset classes afterhours). This lets you react to news and press releases, even if they are made outside normal trading hours. The weekends, though, are usually closed.

All this freedom implies an OTC nature of the product. The freedom of entry and exit points, in both time and price, plus the ability to choose from a very large range of underlyings, gives a distinct allure to CFDs (and OTC products in general), because customization can be deep. For liquid underlyings, spreads aren’t locked into stepped prices like options, and you can enter and exit whenever you want. You can’t trade such customized derivatives on the exchanges.

There are yet further advantages. Not only is extremely high leverage possible, it is also possible to have low transaction costs. Due to fierce competition in the CFD brokers market, many brokers offer quite low commissions. They are usually a percentage of the contract, but there are advertised commissions as low as 0.1% on some equity CFDs.

Initial deposits can be quite low to open an account, and the competition also forces spreads to close. Sometimes CFD providers will bake the commission into the spread, so tighter spreads can also mean lower transaction costs. Ultralow transaction costs and high leverage make CFDs ideal for small-profit-margin trading techniques.

trading levelsFurthermore, even though the trader does not directly own the underlying, s/he is fully exposed to it. This implies that corporate actions, such as dividends, will impact the CFD holder. This is usually done as a cash adjustment to the balance of the trader’s account. Other corporate actions, such as splits and mergers are accounted for by adjusting the CFD position or even opening a new CFD position for the merged/spun-off portion. In other words, your CFD position will mirror whatever happens to the underlying. (Be careful with US based underlyings, though, as they are popular but subject to more stringent rules).

And with 24-hour access, the question of daytrading arises. Are trades under 24 hours day trades, or are day trades only the trades done within normal trading hours? What about after hours? Is midnight the cutoff? Well, with CFDs, oftentimes daytrading rules and restrictions don’t apply. To be able to day trade in the United States, one needs an account with at least $25,000 in equity. However, to gain exposure to the market (US residents may not trade CFDs), you can use CFDs and you don’t have to worry about that restriction. You can make as many trades as you want.

One great aspect of not owning the underlying is that you can take positions on other derivatives, like options and futures, without the possibility of delivery. You also are not exposed to the risk that an option will be exercised, because you are not the option’s owner. When the underlying expires, you can expect either a cash settlement or automatic rollover. That is broker specific.

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Disadvantages

So far, we have outlined several advantages of CFDs. What are some disadvantages? The disadvantages, as is the case with many financial products (and especially derivatives), are largely attributable to the individual who is trading. CFDs also share the same disadvantages as trading equity (on margin or not).

First, margin provides for great profits, but it amplifies losses just the same. If the trade goes against you, you could be in for losses greater than your deposit. It is a symmetric relationship: amplified profits, amplified losses. This just means you need to be careful. Whether this is a disadvantage or simply a signal to be more careful is up to you. The disadvantage to investing in general is the risk of the loss of capital. The high leverage of CFDs doesn’t carry a different disadvantage, it is just magnified.

Another important disadvantage to consider is financing costs. Because this is a leveraged product, you will be paying interest on whatever you borrow. Make sure you add this to your risk-reward model, because CFDs are designed for high leverage – that means you will be paying more in financing costs than just trading in cash or on little margin.

One main disadvantage, which does not apply to many other forms of trading available to retail investors, is the OTC nature of most of these products. Since there is so much freedom in opening and closing, as well as which underlyings to speculate on, there is not much standardization. Furthermore, a contract is opened with a specific counterparty, so you cannot buy the CFD from Provider A and sell it to Provider B. Be aware of counterparty risk. The lack of readily available analysis may be a deterrent to inexperienced traders.

The other big disadvantage that doesn’t apply to regular equity trading is that you do not have voting rights. While most CFD traders are probably not interested in shaking up management, you should note that, with CFDs, you cannot expect to attempt a leveraged buyout or hostile takeover. You don’t receive voting rights, so don’t expect to beat a small competitor by buying up CFDs and then attempting to absorb the company. You don’t own the underlying anyway.

The biggest disadvantage is not even a disadvantage, but something you must be careful with. Leverage is useful, but you need to manage it well. Some may find the absence of exchange-traded products unnerving, but it offers customization. Counterparty risk is real and you need to account for it. Finally, if you want voting rights, CFDs are not for you.

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How it Works

So, you know some of the advantages and disadvantages. You know the risks, and you are ready to try it. How do you do it?

Finding a Provider and the Risks

First, you need to find a CFD provider. It may be a standard broker, or it may not be. As this instrument is somewhat controversial, it is actually disallowed in two huge financial markets. US and HK residents cannot trade CFDs.        There are others, and some many countries place restrictions on trading foreign underlyings. You need to check with your broker and verify your own situation. Much of Europe allows CFD trading, and Australia even tried to standardize them on an exchange, but even Australia has some restrictions.

Once you’ve confirmed you’re a resident of a country that allows these types of trades, you need to find the right broker. There are plenty out there. Many big-name brokers, especially ones that provide international trading facilities, also provide CFD trading abilities. Furthermore, many spread-betting brokers offer CFDs in parallel with their spread-betting platforms.

You need to be aware of one important risk here: counterparty risk. Because these are derivatives, you are entering a contract with the provider. If the provider is not hedging its CFDs in the market (by entering an offsetting trade in the market), the provider is open to major losses. Two risks arise from this: first, if the provider is not hedged, it is probably betting against you. When the trade goes the wrong way for the provider, it might get ugly. Since the prices may not reflect the market exactly, the provider could spike their price to cause you to hit a stop loss. If you do not have direct market access, then you are at the whim of the provider’s pricing.

The other counterparty risk is actually getting your money. If the provider isn’t hedging, it stands to become insolvent. If the provider is very wrong on the trend, without hedges, the provider itself may go bankrupt, and you won’t get all your money. Furthermore, due to the OTC nature of the product, if your provider goes under, your CFD position isn’t worth anything at another provider. These are not, for the most part, exchange traded.

In conclusion? Be careful with your provider. Find a reputable one, preferably one that offers significant transparency.

 

Direct Market Access Route

If you don’t want the broker-style service (quote-driven, where you take the bid/ask that the provider supplies), you may want to look at Direct Market Access (DMA). It lets you deal directly into the exchange’s books, and, coupled with Level 2 quotes, you can see exactly what is being traded. You may also get tighter spreads, but competition among providers has already driven spreads down a lot. When deciding whether you want DMA or not, note that there are extra associated costs with both Level 2 quotes and having direct access to the exchange.

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Opening and Closing Positions

After you have successfully opened an account, you can start looking for trades. As stated above, the high customization of the instrument allows you to enter very close to the actual market price. Let’s do an example. All of these numbers are arbitrary and may be exaggerated for clarity.

Assuming you have a quote-driven service with a hedging provider, when you open your position, the provider will make an offsetting trade in the market. You enter a contract with the provider as counterparty. That contract is between you and the provider only, so know your counterparty risk. You will not be dealing in the asset, solely a synthetic derivative.

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Vodafone Example

You buy 1000 CFD units on Vodafone. The current stock price of Vodafone is £15, and the bid/ask on the CFD is 1490p/1510p (usually quoted in pence or cents). You are taking a market position of £15,100 (1000 times the ask price). But you do not offer up £15,100 for the shares: you lock up the initial margin (let’s say 3%), which is only £453. If your provider bakes the commissions into the spread, that’s all you pay. For our example, let’s say the commission is 0.2% of the contract value, because this is a well-known stock. So, your commission costs are £30.2.

What’s next? If you sold your position immediately, you would lose 20p, because you would have to sell at the bid price (1490p). That would mean an instant loss of 1000 * 20p = £200, plus the commission. But you don’t want to do that, because you just opened the trade. Let’s look at an increase and a decrease.

Increase

Say Vodafone rises to a 1550/1570 spread a few hours later (before the end of the day, otherwise this example becomes complicated by overnight financing costs). The underlying rose 60p, assuming the spread differential remained the same. Your closing price point is 1550p for a gain of 40p over your entry. With 1000 CFD contracts, that translates to £400 minus commissions. The opening commission was £30.2, and the closing commission will be £31, hence £61.2 in total.  Your overall profit is £338.8. With an initial outlay of £453, you just made a 74.8% gain.

Decrease

Let’s look at the other direction of that trade. Say Vodafone stock fell by 60p. Do you lose about £512 (deposit plus adjusted commissions)? Not quite. You have to factor in the fact that your entry price point is the ask, but your exit point is necessarily the bid (unless you’re shorting).

With a 60p drop, you are looking at a bid/ask of 1430/1450. From your entry point, you are down 80p (note the 20p loss from the spread). Your closing commission is a bit less (1430*0.02 = 28.6), so your total commission is £58.8, but your capital loss is 14,300 – 15,100 – 58.8 = -858.8, or 189.6%. This example should clearly illustrate the risks involved in highly leveraged trading. It is perfectly possible for you to lose more than your deposit, so be aware of that from the beginning. CFDs are great tools, but there are risks.

CFDs are shortable, too, so you can easily imagine the opposite scenario for a short position. The same risks apply as shorted equity, though with such high leverage, you probably don’t need to worry about the unlimited downside of shorting, because you’ll hit a margin call way before that. I trust you are sophisticated enough to calculate your own example of a short trade.

Something that may be a bit confusing, though, are corporate actions. How are these handled when you don’t own the underlying?

Corporate Actions

Dividends

Say your underlying pays a dividend while you have an open long position. Your provider will perform the simplest adjustment, which is a cash adjustment directly in your account. So, for example, say you hold 500 CFD shares of MSFT, which you bought at $50/share and the price of the stock froze at that point. If you hold it when the stock goes ex-dividend, then you will collect the dividend. Say it is $1.50/share (a flat 3% yield). Assuming a 5% initial deposit, then you collect $750. Your original investment was $1,250 (500 * 50 * 5%), so your profit isn’t just 3%, but, because you are leveraged 20:1, you take a nice 60% return.

That is all great. But be extra careful with this, because the downside is the same. If you are short on a stock CFD and it goes ex-dividend, you must pay that amount. You just took a 60% loss, simply because you held it when it went ex-dividend. This is probably the easiest losing trade to avoid, because big companies will have predetermined dividend dates and they will announce it early. If you lose money because you must pay a highly-leveraged dividend, you did not do your due diligence, and that is entirely on you. Dividend losses are predictable, with the exception of surprise dividends, so falling victim to these should raise a huge red flag on your trading model.

 

Stock Splits

Another relatively common corporate action is the stock split. For CFDs, you can expect to have a position adjustment. Again, this is the easiest for the provider, because it directly mirrors what happens to the underlying (which they should have an offsetting position in). If you have 200 CFD shares and the underlying splits 3-for-1, you will then own 600 CFD shares at the adjusted price.

The action of splitting is uninteresting. The interesting part is the denominated currency’s smallest unit, because a one-cent change in a $15 stock is different from a one-cent change in a $5 stock (0.067% vs 0.2% change, actually). You can’t trade less than the unit currency, so the smallest change possible shifts. If you’re concerned about one pence or one cent movements, keep this in mind.

It is also important to note that spreads do not necessarily scale with the split, so the original spread may have been 1498/1502, but the new spread is now 499/501. That’s a 2:1 ratio, not a 3:1 ratio like the split. Algorithms need to account for this (if you’re an algo-trader).

Reverse splits would be the same process, except backwards. Since most providers charge commission on the overall purchase/sale or bake it directly into the spread, you won’t have to worry about commission changes due to the number of shares you are selling. In fact, you aren’t selling any shares of the company but only CFDs.

 

CFDs on other derivatives

We have talked a lot about equity CFDs, but if you are interested in the options, futures, or commodities market (especially due to the elimination of exercise and delivery risk), you can find CFDs on those products. For underlyings that expire, most providers will make a cash adjustment to your account or automatically roll your position over. If you go long on a daily-settled call option, you can expect the change in the price of the option to be your profit (or loss), and the movement is accounted for in your account’s daily cash adjustment.

Furthermore, some contracts may have money-to-point ratios that are not one (not directly correlated). For example, a daily option on the DAX30 may represent €5/point. This means the cash change for one contract is €5 for every one point change in the DAX30 instead of €1/point.

Tips and Strategies

So far, we have discussed what CFDs are and a bit about how they work. Now, let’s look at a few basic strategies for trading CFDs. I am not going to outline common equity trading strategies, either in technical or fundamental trading. If you plan to trade CFDs, you probably know about crossovers, bands, stochastics, and other technical indicators. If you are seasoned, you probably have your own proprietary indicators. You can use CFDs to mirror those strategies with high leverage and the other advantages of CFDs.

In this section, I want to elucidate broad concepts that may be helpful when transitioning to CFD-based trading. I will also give a couple techniques that are available to equity traders, but that are better served by the high leverage of CFDs.

 

Long vs short term

The first thing is long and short term trading. CFDs are especially well-suited to short-term trading because of the high leverage, high liquidity of many underlyings, and low transaction costs. A long-term strategy is certainly possible, but you should factor in financing costs. You also need to be wary of dividends if you are going short, and you have to be vigilant about big price swings. If you want to use CFDs long term, they are probably best used as a hedge against your existing, non-CFD portfolio. By long-term, I mean more than a couple months. Swing trading with CFDs is by no means a bad trading style.

I do want to point out that using CFDs to hedge is a perfectly valid strategy. It is best to use it in choppy markets, because you don’t have to tie up a lot of capital and the transaction costs are minimal. You can protect a big portfolio with little money, and, if you mirror it correctly, the only cost is financing. Think of the financing costs as analogous to the premiums paid in options hedging.

 

Daytrading and Swing Trading

Now that you probably aren’t going to go too long-term with these instruments, it is now up to you to determine whether you will go very short (intraday, perhaps down to a few seconds) or extend your trades out for a couple weeks (swing trading).

Regular daytrading is very suitable for CFD trading. You have no daytrading restrictions (because you don’t own the underlyings), the costs are quite low for entering and exiting trades, and you can make decent returns by employing leverage. Daytrading is probably the best suited to CFD trading. You’ll need good market quotes and execution times for this.

Daytrading has been described as “white knuckle trading” because it can be very intense. You are moving in and out of trades quickly, and most daytraders use very tight stop loss triggers. But even tight stop losses can cause significant losses with high leverage, so you need to be very calm and methodical if you will daytrade. Know your own stress points and stay unemotional.

Swing trading, on the other hand, is also good. You do need to incorporate financing costs into your model, especially if you’ll be highly leveraged, but you could reduce your leverage to reduce your financing costs – this is especially attractive if you are interested in CFDs mainly for foreign exposure rather than leverage.

 

Scalping

The most intense daytrading technique is probably scalping, which is basically noise trading – you are looking for small movements in the price. These movements are noise, and often occur because markets are not entirely efficient. Scalping with traditional trading accounts can be difficult because of the low margins and the high transaction costs, so CFDs have a big advantage here. This technique can be rewarding, but you must have nerves of steel. Having an automated trading system may work, because there is presumably no emotion in code.

You must also have a reliable, honest provider. You can’t scalp if your broker is taking a few points for the spread or not executing your trades fast enough. Scalpers need tight spreads, because their expected movements may only be a few cents, and they need to execute quickly to lock in those precious few-cent moves.

 

Dividend Stripping

First, be aware that if you short, you will be paying the dividend. Consider this a warning. Failing to account for dividends (and especially the ex-dividend date) can see your account cash-settled much lower than you anticipated

Dividend stripping is one trading strategy that most equity traders will know already. The big advantage for the CFD trader is the big yield. The dividend may only represent a 1% yield on the share price, but if you’re levered up by 25:1, the dividend will be a 25% profit for you.

As any trader knows, once the stock goes ex-dividend, the price will drop by the dividend payment, since the dividend is no longer attached. This is very important for CFD traders because of margin calls. With the high leverage, you can easily hit a margin call if the market has a small overreaction and the price falls farther than the dividend payment. If you’re setting tight stop losses, you will probably hit it on ex-dividend date. Don’t forget this and end up wiping out your dividend gain plus a few points from the overreaction.

 

Know Your Entry and Exit Points

Trading requires discipline. That discipline means choosing entry and exit levels for logical reasons, then adhering to those points. Yes, things change, but without big news or a logical trigger to change it, DO NOT change your entry and exit points. You set these for a reason, and if you change the points, you are discounting those reasons.

It is a good idea to set stop loss and limit orders. Once these are set, don’t change them. If you become fearful of losses, you can lose more. Furthermore, due to the high leverage on these products, it is easy to trigger margin calls – don’t get caught being forced to liquidate at very low prices because you got emotional and lowered your stop loss order then hit a margin call. Even more: if you hold losing securities overnight, you will incur the financing costs on a losing trade.

When the trend is in your favor, don’t get too greedy. You can set trailing stops, especially if you feel the trend is strong and in your favor. But if you predicted a high point, for logical reasons based on your models, stick to it. You don’t want to fund a CFD position overnight to see all your gains erased at market open because you ignored your predicted high.

Use stops. Use limits. Trail your stops when the trend favors you. Do not move your stop losses down or your upper limit orders up, unless you have a compelling, calculated, logical reason.

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Trade in Liquid Assets

This is especially important when you are highly levered. It is never a good feeling to wake up to a stock that moved 15% overnight due to low liquidity. If you see the security moves by big jumps most of the time, avoid CFDs on it! Gapping is a real phenomenon, and it happens much more often on low-liquidity assets. Plus, the spreads on low liquidity assets tend to be wide. They will be wide on the CFDs, too.

With that said, a lot of brokers won’t even offer CFDs on risky underlyings, because they cannot hedge their own position. Or they may not be interested in hedging it, so they won’t offer it. If they do offer it without hedging, you open yourself to counterparty risk. On another note, they may find it difficult to justify lending you so much margin funding for stocks that only make big moves, because those big moves mean large losses for you when it goes wrong.

Be aware of the currency

This is a tip that seems ridiculous, but if you start trading many foreign indices or markets, you can forget what the currencies are. Most providers will settle the CFD in the currency of the underlying, so you need to make sure you reduce your FX risk. You could do that with CFDs if you want, or you could use more traditional methods.