CFDs
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Contracts for difference (CFDs) are popular financial instruments that can provide investors with access to asset classes that might otherwise be unavailable to them. However, they can appear complicated at first, so, what are CFDs and how do they work?

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What are contracts for difference (CFDs)?

Contracts for difference are derivative products, financial contracts between two parties, whose value is dependent on the assets that they are linked to.

How do CFDs work?

CFDs are traded directly between a customer and a broker, and this is typically referred to as an over-the-counter (OTC) derivative transaction.

Contractual terms will vary depending on the broker in question, although they typically have some elements in common:

• CFDs are started by a position being opened on a particular asset with a CFD broker.
• Most CFDs do not have expiry dates — the position is closed when a reverse trade is made, and the difference between the opening and closing trade is paid as profit or loss.
• Brokers will typically charge overnight fees for keeping CFD positions open.

CFD business models

Different brokers will utilise different CFD business models.

Market-maker (MM) model

The broker sets the price for the CFD and takes all orders onto their own books according to whichever risk model they have implemented. The price of the CFD might differ from that of the underlying market as the broker takes additional factors into account.

Direct market access (DMA) model

The broker enables CFD trading at prices that mirror those available in the underlying market. When a CFD order is submitted, the broker executes a hedge order — an order for the same instrument, but in the opposite direction — to ensure that each CFD trade is matched on a one-for-one basis.

Multi-asset trading with CFDs

CFDs can typically be used to trade a range of different assets, although this will depend on the broker in question. This can include:

• Currencies
• Commodities
• Indices
• Stocks
• Bonds

Key CFD terms

When trading CFDs, it is important to understand some key terminology:

• Corporate action — an event initiated by a public company that impacts the securities issued by said company
• Stop order — an order to buy or sell an asset once its price reaches a specific level
• Gapping/slippage — the difference between the price at which an order is expected to be executed and the price at which it is actually executed (either positive or negative)
• Point — a unit of measurement that denotes the smallest possible price change on the left side of a decimal point
• Percentage in point (PIP) — a unit of measurement that denotes the smallest possible price change on the right side of a decimal point

Leverage and margin with CFDs

CFDs are traded using leverage. This involves taking funds, referred to as “margin”, and using them to gain access to a larger quantity of assets. An investor pays a percentage of the value of the underlying CFD to open the position, rather than the full value.

For example, if an investor had $100 to invest in a CFD, but the broker was offering leverage of 1:5, the investor could theoretically open a position worth $500. This allows them to open a larger position with less capital, but it would also magnify any losses made.

Margin rates

The margin rate refers to the interest rate applied when investors engage in leverage and margin trading. This rate is set by the broker and will often vary depending on the asset being traded.

Benefits of trading CFDs

There are a number of advantages to trading CFDs:

• Access to global markets — CFDs provide access to a range of markets that might otherwise be unavailable to retail investors
• Leverage trading — leverage trading enables investors to open larger positions with less capital
• Short selling — CFDs can allow investors to potentially profit from falling prices (“going short”) as well as rising prices (“going long”). Investors can, therefore, use CFDs to hedge against potential losses elsewhere within an investment portfolio

Risks of trading CFDs

There are, however, several risks associated with CFD trading:

• Leverage trading — leverage trading can magnify any losses made on an open position
• Volatility — CFDs are linked to underlying assets and will, therefore, be impacted by the market conditions that affect those assets
• Liquidity — if the underlying asset being traded is illiquid, or trading is suspended on an exchange, it can be difficult to trade the CFD or close out a position

CFD fees and charges

CFDs are subject to fees and charges that may not be incurred when trading other financial instruments. These fees will differ depending on the broker in question, and can include:

• Overnight fees
• Margin rates
• Interest on short positions
• Commission

Good CFD trading practices

Because of the risks associated with CFDs, it is important to implement some good trading practices.

Positions should be managed using stop-loss or take-profit instructions, which will automatically close a position when its price reaches a certain level.

It is also important to diversify your investment portfolio and avoid allocating all of your capital to a single CFD position.

Final thoughts

Contracts for difference can provide additional opportunities for investors, by allowing them to trade a variety of assets, and also by enabling the use of leverage to open larger positions. However, CFDs are a risky endeavour, and significant research should be conducted before committing funds to a trade.

Visit the eToro Academy to learn more about contracts for difference.

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