CFDs or contracts for difference are a financial product developed to be able to invest, enjoying all the advantages of buying shares, currencies, raw materials,… but without the need to physically acquire the ownership of those instruments. The investor adheres to a CFD contract at the price in effect when a position is opened and collects a profit or assumes a loss when the position is closed if the price moves in his favour or against him respectively.
CFDs are so-called OTC or “over the counter” derivative instruments because they are not traded on an organised market. CFDs are issued by financial institutions, in this case online brokers, which must be legally authorised to do so. More info: What is a Broker?
Originally, they were only accessible to institutional investors but over time they have become a very popular investment instrument among small investors around the world, thanks to their great flexibility. They allow us to trade any asset that no other financial product can offer. However, we must take into consideration a series of questions regarding its operation for its correct handling which we will analyse in this article.
How do CFDs work?
As you may have gathered, this type of contract is more flexible because you do not need to buy the instrument you want to trade as it is only a contract that replicates the price of that instrument. It is as flexible as, not only can we buy and then sell, but it is also possible to sell an asset without owning it and then close the position with a purchase, thus achieving the possibility of making a profit on both upward and downward fluctuations in the price of the instrument.
Let’s explain it in detail:
– With CFDs, the investor can open a buy position (calledgoing long) and then close the position by selling. If the price of the security he is buying increases between opening the position and closing it he will make a profit and if it has decreased he will assume a loss
– The investor can also open a sell position (called“going short“) and close the position later with a buy if he believes that the value he is trading will decline in price. In this case he will make a profit if the price has fallen between opening the position (selling) and closing it (buying) or he will assume a loss if it has not.
Let’s now look at other important aspects that take place when trading CFDs:
In the previous point we have noted the flexibility of CFDs in terms of their operation, but this is not all. When trading CFD’s you don’ t have to pay the price of the investment in full but only have to provide a portion as collateral. This is called using “leverage“.
When trading CFDs, both long and short, what we do is trade as if we were actually buying or selling a certain amount of a certain financial asset (e.g. 100 barrels of crude oil, 200 shares of Apple, etc.). The amount to be invested or volume of the operation can be adapted to our level of capital. The greater the amount, the greater the possible profit or loss.
For example, if the instrument in which we want to invest is quoted at a certain price, let’s take 10 euros as an example, and we want to buy 300 units, the total purchase price would be 3,000 euros. When trading CFDs it will not be necessary to pay the 3,000 euros. Normally the broker will only ask us for a certain percentage as a guarantee to open the position.
The level of leverage is determined by the amount we have to deliver. In this respect, each broker can offer certain conditions that are permitted by the regulations in force and they usually vary from one instrument to another (it is not the same level of leverage that they offer for trading, for example, in currencies as in shares or commodities).
For example, a leverage of 1:30 means that for every euro deposited as collateral we can open a trade worth 30 euros. If in our previous example the operation was for 3,000 euros, depositing 100 euros (3.33%) as initial margin of guarantee is enough.
You will clearly see how our level of capital required to make a trading operation is drastically reduced thanks to the leverage. It offers us the possibility of significant profits with little capital but also entails greater risk if the price does not move in our favour so it is very important to protect ourselves against possible losses.
A protection measure is for example opening small positions by trying to risk only a small part of the available capital in our account on each trade. Another is to always place a stop loss to cut possible losses.
There are also certain mechanisms in place so that if open positions move against us, we do not incur debt to the broker. When the available capital in your trading account falls below a certain risk amount so that you cannot sustain any further losses, the broker will warn you (you will receive a “margin call“). From here we have two options:
- Deposit more amount as margin.
- We will automatically close any trades that are necessary to bring the available capital back above the required margin.
Leverage has both advantages and risks. You trade with more than you put in, for better or for worse. That’s why it’s often reported. You can read more about it in this article:
How to use leverage intelligently
There are a number of common commissions when trading CFDs that you should be aware of:
The spread is the most common commission rate when trading CFDs. The spread is the difference (“spread” means “spread”) between the price the broker offers us to buy a CFD and the price he offers us if we want to sell it.
When we trade CFDs we will see that the broker offers us two prices on their trading platform:
- Bid: The price offered to sell a CFD, either to open a short position (if we believe that the price will go down by selling first to buy later) or to close a long buy position that we have previously opened.
- Ask: The price offered to buy a CFD, either to open a long position (if we believe that the price will rise by buying first to sell later) or to close a short sale position that we have previously opened.
The ask price will always be a few points (called pips) higher than the bid price. The difference is the spread and it is the broker’s fee for trading.
Let’s take an example to understand it better:
Suppose you want to trade CFDs on the Forex market, look at the currency pair GBP/USD (British Pound vs. US Dollar). Let’s also assume that you want to go long and buy the pair (which means buying the GBP in exchange for the USD) hoping that the GBP will appreciate against the USD.
At this point we will have two prices, for example these:
Bid (sell the CFD): 1.3050 (this means that each pound is exchanged for $1.3050).
Ask (buy the CFD): 1.3053 (as you can see it is 0.0003 higher).
Our intention is to open a long position by buying the currency pair. If we were to buy and sell immediately, we would incur a loss of 0.0003 per unit of currency purchased (depending on the size of our investment). If we sold and bought immediately (in case of opening a short position), we would have the same result.
Naturally the price will fluctuate, but there will always be a differential between the two prices. Depending on the conditions of our online broker, the spread may remain fixed (fixed spreads) or vary according to market conditions (variable spreads).
As a general rule, the broker will apply the spread as soon as the position is opened. In other words, the operation begins at a loss because, although the price advances in our favour, we must first recover the spread before going into profit.
– Swap or overnight fee
We have previously discussed leverage and the absence of the need to deposit all the funds required for the operation. Well, now it is time to talk about the cost of using this leverage. Swap is nothing more than a cost of financing as CFDs are a leveraged contract.
The money from the transaction, which we do not deposit, is a loan from the broker to us. This loan is subject to the interest rate of the currency involved in the operation. For example, if you open a CFD trade on the Dow Jones 30 index, your trade will be denominated in dollars, because the index is quoted in that currency. Consequently, we will be charged interest on the dollar.
Every day the broker will charge us interest on the funds used in the transactions. This fee for borrowing funds (leverage) is usually settled in the Forex market at 11pm, for this reason it is also known as “overnight fee“.
It may also be called “rollover“. Since it also involves a rollover of open trading operations.
In the Forex market, when we open a position there is not one, but two currencies involved. This has an impact on the swap commission. The currencies are quoted by pairs. One currency must be against another to establish the exchange rate between the two. Therefore, we trade two currencies simultaneously, one bought and one sold.
Each currency pair consists of the base currency (the first currency in the pair) and the counter currency (the second currency). For example, in the euro-pair against the US dollar (EUR/USD) the base currency is the euro and the counter currency is the dollar. Each currency has its own interest rate. In this case the broker will charge us the interest on the currency sold and pay us the interest on the currency bought. The swap is then determined by the difference in the interest rates of the two currencies and may be in the trader’s favour and involves a credit to the account rather than a commission charge.
– Commission for operations
There are some brokers, usually those offering ECN (Electronic Communication Network) execution accounts, which usually apply a very low or even no spread but charge a fee for each trade depending on the size of the position.
You can see more information about spreads, swaps and other commissions in this article:
More frequent commissions when trading
Advantages and disadvantages of CFDs
By now you will have seen that trading CFDs has many advantages and also some risks that you need to be aware of and control:
- CFDs are a financial product (derivative) that allows individual traders to access trades and markets that have been reserved for professional managers. Thanks to the leverage, you don’ t need a lot of capital to trade any asset.
- We have the ability to select a size of each trade to suit our capital levels.
- They allow a very active management of trading operations, making very short term positions viable. They are ideal for short term investment strategies such as day trading and particularly scalping (opening and closing positions in a matter of minutes or even seconds to take advantage of small price fluctuations).
- They are a highly flexible product, which allows us to carry out hedging operations or other more complex strategies.
- Itis not necessary to assume ownership of the financial asset. This is especially a plus when trading in the commodity market. It also avoids the custody fee for keeping the financial assets in the portfolio.
- Contracts for difference are very liquid instruments. They allow you to buy and sell in a matter of seconds. As well as the possibility of establishing automatic stop loss orders. Even take-profit orders.
Disadvantages and risks
- Leverage can be a double-edged sword. The trader must properly manage money and risk management (More info: 5 Basic Money Management Rules you should follow). What in principle can be an advantage, also presents a high risk if not used properly. The losses that we may have are a function of the total of the operation, not of the margin of guarantee deposited.
- Due to the leverage, some financial authorities have classified CFDs as high risk products. There is no guaranteed return and the investor may lose the entire amount invested or even incur a debt to the broker (retail investor accounts often incorporate negative balance protection measures to avoid this). Investing in CFDs is not suitable for all investors so make sure you fully understand the risks before investing in this product.
- The need to pay daily interest to keep trades leveraged (swap fee) means that medium to long term trading performance suffers. CFDs are not suitable products for long-term investment.
- CFDs are Over The Counter ( OTC) products. They are not traded on an official market and are therefore a contract between the broker and the client. It is therefore very important to only work with reliable brokers who are duly authorized and regulated to trade this type of product. More information: How to choose the right onlinebroker?
What do you need to trade CFDs?
- Opening a CFD broker account: Most of these types of financial transactions are entirely online. It is possible to open an account with one of these intermediaries in a matter of minutes by accessing their website. From here, the broker will guide you through the process and provide you with all the necessary tools. More info: What do I need to open an account with an online broker?
- Funding the Account: Naturally, in order to undertake our CFD trading operations, you will need to have funds to leave as initial collateral (and additional margin). After opening an account with the broker we must deposit a certain amount as initial capital through various means of payment (bank transfer, credit or debit card, electronic purses,…).
- Manage the trading platform: The broker will make one or more online trading platforms available to us free of charge. The trading platform is the fundamental tool for carrying out our operations. From it we will be able to analyse the markets, control our account, open and close positions, establish the different orders. In short, take all kinds of decisions and manage our operations.
- Demo Account: In order to familiarize ourselves with the trading platform, try out new strategies and gain experience it is very common for the broker to offer us a demo account in which we can trade, in an environment similar to a real account, but without putting our money at risk. This is a kind of simulator with fictitious money with which we can (and should) practice. This tool is very important and useful to learn how to invest and see how the aspects we have seen in this article work such as leverage, spreads, risk management tools,… More info: How to use a demo account to learn how to trade
We hope this article has been useful for you to learn what CFDs (contracts for difference) are and how these financial instruments work when trading online. You can send us your comments and also help us spread the word by sharing it on social networks so that it can reach other people who might find it useful. Thank you.