You may have noticed that many online brokerages offer CFD trading in addition Spot Forex, but what exactly is a CFD? CFD’s (Contracts for difference) were developed in the early 1990’s and allow a trader to trade various financial markets without owning the underlying markets. It wasn’t until the late 90’s that Contracts for Difference took off as a popular retail instrument and there are now a number of different brokerages offering a wide range of CFD’s. Contracts for Difference are available in a number of different countries and have become very popular with speculators who want easy access to a variety of financial markets.

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How Do CFD’s Work?

A Contract for Difference is a contract between two parties referred to as a buyer (typically a retail client) and seller (typically a brokerage). The contract stipulates that the Seller will pay the buyer the difference between the contract price and the price of an asset at the close of the contract provided the difference is positive. If the difference between the quoted contract price and the current price of the asset is negative the buyer will pay the seller the difference. CFD’s are financial derivatives that allow retail traders and hedge funds to take both long and short positions on a range of different financial markets. While CFD’s appear to be rather complicated in practice they are a relatively simple, this can be brought out in a number.

Example 1

A trader believes that shares in Big Retail Company PLC will rise. The trader acts on his believe that the company’s share price will rise by phoning his CFD brokerage to place a trade. The brokerage quotes our imaginary trader a Bid/Ask (Sell/Buy) spread of 98-102, with the underlying asset currently trading at 100p. He immediately buys 300 long/buy contracts from the brokerage (each equivalent to one share) and later that day the price rises to 110p. Our trader then closes his position at a profit of 8p per contract (110 – 102) making a total profit of £24 (0.08*300).

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Example 2  

In our second example a trader believes the share price of Chocolate Treats Plc will fall. The trade places a sell trade on his brokerages online platform. The brokerage quotes him a Bid/Ask (Sell/Buy) spread of 45-55, with Chocolate Treats Plc currently trading at 50p a share. He buys a total of 500 sell contracts and later that week the price rises to 75p. To prevent further losses he closes his position at loss of 30p per contract (45 -75 = -30) taking a total loss of £150 (0.30*500).

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As you can see CFD trading is very similar to traditional share trading and those who have engaged in standard trading should have no issues with getting to grips with CFD’s.

Charges and Commission

When holding a CFD position overnight clients may be charged a daily financing charge. This financing charge is agreed prior to the opening the position and is typically based on the LIBOR plus a fixed interest rate. Sometimes those holding a short position may receive a payment from the brokerage/seller. Traders need to take account of these charges and commission when opening a position they intend to hold overnight.

Again some CFD brokerages will charge traders commission either at a fixed rate or as a percentage of the total position size. Not all brokerages charge traders commission with some brokerages including commission within the quoted Bid/Ask spread. Again this is something that traders need to consider as commission can eat into your profits and add to your losses.

Leverage

Part of the popularity of CFD trading is that traders can take on significant amounts of leverage, this is due to the fact that CFD trading is a form of margin trading. Traders can take on significant positions with limited initial capital. This can help traders maximise their profits when things are going their way, but will lead to greater losses when things go against. As a form of margin trading CFD trading is not a suitable option for many individuals and traders can lose more than their initial deposit.

Types of Broker

CFD brokerages operate using two different models:

  • Market Maker Model: Brokerages operating using a Market maker model set the price for the underlying asset and will take on client positions onto their own books. This introduces a degree of counterparty risk, thankfully the majority of market makers hedge their positions based on their own risk management model. Market makers can typically offer a wider range of instruments and can sometimes offer traders guaranteed stop losses.
  • Direct Market Access: CFD brokerages offering their clients Direct Market Access guarantee they will execute a matching trade in the underlying market though the contract remains between the client and the brokerage. The Direct Market Access model was created to address concerns some had regarding the Market Maker model; with some believing that there was an inherent conflict of interest. While the interests of a trader and DMA brokerage are aligned with one another, Direct Market Access brokerages suffer from a number of drawbacks. They typically offer a smaller range of instruments and can’t guarantee execution at particular price or offer traders guaranteed stop losses.

Both Market Makers and Direct Market Access brokerages have their own advantages and disadvantages. Traders should seriously consider what type of brokerage to operate with.

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What Can Be Traded?

Many CFD brokerages offer a diverse range of instruments to prospective clients, with it not being uncommon for brokerages to offer Shares, Indices, Commodities, ETF’s and Forex all from one platform. It is not uncommon for CFD’s be offered in particularly exotic instruments, with both AvaTrade and Plus500 offering customers the opportunity to trade Bitcoin CFD’s. With competition between brokerages being fierce, brokerages are always seeking to add new products to their platform.

Why are CFD’s so popular?

CFD’s are extremely popular with speculative traders as they allow traders to profit from a wide range of financial markets without owning the underlying asset. While CFD’s appear to be a complex instrument, those who have experience with traditional share trading should be able to get to grips with CFD trading in no time. The fact CFD’s are a leveraged instrument meant that they won’t be suitable for everyone and traders should appreciate the significant risks involved. It is likely that CFD’s will continue to be popular with those who want to trade the financial markets.

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