‘Contract For Difference’ mostly called CFDs is known to be a popular and innovative investment tool which allows you to trade on the price movement of any financial market like stocks, commodities, indices and Currency without actually owning the underlying instrument.
CFD trading offers traders and investors an opportunity to speculate on the price movement of the assets, without owning the underlying asset itself. In contrast with traditional investments, CFD trading allows traders to take positions on falling prices as well. Since owning the asset is not a condition with CFDs, an investor can sell the asset and profit when prices fall or lose when prices go up. CFD trading also gives investors access to the global markets - such as shares, cryptos, indices and commodities - in a single trading environment.
If a stock has an ask price of $25.26 and the trader buys 100 shares, the cost of the transaction is $2,526 plus commission and fees. This trade requires at least $1,263 in free cash at a traditional broker in a 50% margin account, while a CFD broker requires just a 5% margin, or $126.30.
A CFD trade will show a loss equal to the size of the spread at the time of the transaction. If the spread is 5 cents, the stock needs to gain 5 cents for the position to hit the break-even price. While you'll see a 5-cent gain if you owned the stock outright, you would have also paid a commission and incurred a larger capital outlay.
If the stock rallies to a bid price of $25.76 in a traditional broker account, it can be sold for a $50 gain or $50/$1,263 = 3.95% profit. However, when the national exchange reaches this price, the CFD bid price may only be $25.74. The CFD profit will be lower because the trader must exit at the bid price and the spread is larger than on the regular market.
In this example, the CFD trader earns an estimated $48 or $48/$126.30 = 38% return on investment. The CFD broker may also require the trader to buy at a higher initial price, $25.28 for example. Even so, the $46 to $48 earned on the CFD trade denotes a net profit, while the $50 profit from owning the stock outright doesn't include commissions or other fees. Thus, the CFD trader ends up with more money in their pocket.
Over-Leveraged Positions: The greatest error that new traders make is the option to risk too much on a specific position. ‘Over-leveraging’ occurs when inexperienced traders turn to CFDs thinking it will make them wealthy. When a potential opportunity to place leveraged trades is made (hoping for improved gains), most new traders go overboard and endure huge loses (or maybe the disintegration of a whole trading account) as a result.
Excessive Trading: Minimal capital requirements and simplicity of access can result in excessive trading.
Positions Held Overnight: Overnight positions might endure overnight financing (which is comprised of a daily cost as per the contract size, which is associated with Libor). Long trades with extended durations allure higher interest payments. Interest fees for long positions held over lengthy durations (at least three months) can decrease the impact of returns substantially, making the leverage acquired no different than completely purchasing a share or contract in the market.
Trading Shares is a Lower Risk than Trading CFDs: While a deposit of the entire value isn’t required, your initial margin could still be lost. Also, if the market isn’t moving in alignment with you, you might have to meet a margin call that requires more funds. This could leave you in a spot where you have no choice but to sell down assets. Investors may endure an unlimited loss for a short position.
Dividends: If a short position is held over the record date, traders who open a short CFD position are inclined to pay out the total dividend value.
Risk of Volatility: Several CFDs (for example, cryptocurrency CFDs) are volatile trading tools. Greater volatility leads to opportunity and risk. That said, it is vital for CFD traders to modify their methods. Failure to do so could lead to the trader facing adverse price movements, stimulating growth of extra margin calls without warning.
The counterparty is the company which provides the asset in a financial transaction. When buying or selling a CFD, the only asset being traded is the contract issued by the CFD provider. This exposes the trader to the provider's other counterparties, including other clients the CFD provider conducts business with. The associated risk is that the counterparty fails to fulfill its financial obligations.
If the provider is unable to meet these obligations, then the value of the underlying asset is no longer relevant. It is important to recognize that the CFD industry is not highly regulated and the broker's credibility is based on reputation, longevity, and financial position rather than government standing or liquidity. There are excellent CFD brokers, but it's important to investigate a broker's background before opening an account. In fact, American customers are forbidden from trading CFDs under current U.S. regulations.
Contract for differences are derivative assets that a trader uses to speculate on the movement of underlying assets, like stock. If one believes the underlying asset will rise, the investor will choose a long position. Conversely, investors will chose a short position if they believe the value of the asset will fall. You hope that the value of the underlying asset will move in the direction most favorable to you. In reality, even the most educated investors can be proven wrong.
Unexpected information, changes in market conditions and government policy can result in quick changes. Due to the nature of CFDs, small changes may have a big impact on returns. An unfavorable effect on the value of the underlying asset may cause the provider to demand a second margin payment. If margin calls can’t be met, the provider may close your position or you may have to sell at a loss.
Client Money Risk
In countries where CFDs are legal, there are client money protection laws to protect the investor from potentially harmful practices of CFD providers. By law, money transferred to the CFD provider must be segregated from the provider’s money in order to prevent providers from hedging their own investments. However, the law may not prohibit the client’s money from being pooled into one or more accounts.
When a contract is agreed upon, the provider withdraws an initial margin and has the right to request further margins from the pooled account. If the other clients in the pooled account fail to meet margin calls, the CFD provider has the right to draft from the pooled account with potential to affect returns.
Liquidity Risks and Gapping
Market conditions effect many financial transactions and may increase the risk of losses. When there are not enough trades being made in the market for an underlying asset, your existing contract can become illiquid. At this point, a CFD provider can require additional margin payments or close contracts at inferior prices.
Due to the fast-moving nature of financial markets, the price of a CFD can fall before your trade can be executed at a previously agreed-upon price, also known as gapping. This means the holder of an existing contract would be required to take less than optimal profits or cover any losses incurred by the CFD provider.
The Bottom Line
When trading CFDs, stop-loss orders can help mitigate the apparent risks. A guaranteed stop loss order, offered by some CFD providers, is a pre-determined price that, when met, automatically closes the contract.
Even so, even with a small initial fee and potential for large returns, CFD trading can result in illiquid assets and severe losses. When thinking about partaking in one of these types of investments, it is important to assess the risks associated with leveraged products. The resulting losses can often be greater than initially expected.
CFD trading carries a high level of risk and may not be suitable for all investors. CFDs are highly leveraged over-the-counter derivatives. You can lose more than your initial deposit and your potential losses may be unlimited.
As with any products that involve the financial markets CFDs are inherently risky. CFD trading is leveraged so whilst it can lead to greater returns on smaller deposits, it is also possible to lose more than your deposit. While stop losses can be allocated to each trade, they may not be guaranteed and will not always be filled at the level you requested in volatile markets due to market gapping or slippage. Investors should also look at the price of commission as many CFD providers have a commission charge.
CFDs are not suitable for everyone. Our message to investors is this: if you don’t understand contracts for differences, then do not invest!
No one can guarantee the performance of any financial product. You can lose all of or more than the money you put in if something goes wrong.
You are taking a considerable risk if you put all your money into one type of investment (for example, trading CFDs). Spreading your money between different types of investments reduces the risk of losing everything.
This educational material does not constitute financial product advice and does not take into account your investment objectives, financial situation or particular needs.
Trading carries a high risk and you should never trade with money you can’t afford to lose. The contents of this CFD trading guide are for educational purposes and should not be considered in any way as investment advice. Ultimately the trader must take responsibility for your own trading decisions.