A derivative that has generated significant buzz recently is a contract for difference (CFD). With a CFD, the difference between the open and closing trade price of a given asset is settled in cash without the delivery of any goods or securities. While CFDs are not allowed in the United States, many experienced traders use them in other markets, including the United Kingdom, Germany, and Switzerland.
With CFDs, people trade in the price movement of securities and derivatives rather than in the products themselves. In other words, traders place bets on whether the price of a specific asset or security will rise or fall. Traders can bet on movement in either direction by either purchasing the contract or selling an open position. In either case, the difference between opening and closing costs is settled in cash through the investor’s brokerage account.
How CFDs Work in the Real World
Traders can use CFDs to trade a wide array of different assets and securities. In addition, CFDs can be used to speculate on price movements in the commodity futures contracts market, such as those for crude oil or corn. Futures contracts are agreements that obligate people to buy or sell assets at a given price within a certain period. CFDs are not futures themselves and instead only allow trade in the price movement of futures. To that end, CFDs do not have an expiration date like futures. Instead, they trade with buy and sell prices like other securities.
CFDs trade through a network of brokers that helps create the supply and demand for these products and sets prices. CFDs are not traded on major exchanges. The contract is between client and broker and is a tradable asset that results in a payment based on the price difference. As an example, imagine someone buys a CFD on an exchange-traded fund tracking the S&P 500 Index. They pay a down payment for the trade when the fund is at $250 per share. A few months later, the fund is trading at $300 per share; the buyer will exit that position with a profit of $50. The contract gets settled in cash and $50 is added to the buyer’s account for every share in the agreement.
The Benefits of CFDs
Traders like CFDs because they provide all the benefits of owning a security without having to purchase it or deliver the asset physically. These contracts are purchased on margin. In the example above, only a small percentage of the price is needed as a down payment. This fee can be as low as 2 percent but as high as 20 percent depending on the broker. Therefore, traders can increase leverage to amplify their gains. As a result, brokers often require traders to maintain a certain account balance before they can transact in CFDs.
In general, there is less regulation around the CFD market than standard exchanges. Brokers tend to offer products in all major markets around the world, so traders have quick access to new markets through these accounts. Furthermore, some brokerages allow traders to open accounts for as little as $1,000. Plus, CFDs are incredibly diverse; investors can take a long or short position, as well as a buy or sell position. Most of these markets do not have short-selling rules, and there are no borrowing or shorting costs since there is never any ownership of the underlying asset.
The Downsides of CFDs
While there are some benefits to CFDs, there is also considerable risk. If the underlying asset becomes volatile and experiences extreme fluctuations, the spread can grow quite large. Unfortunately, paying a large spread on entries and exits makes it more difficult to profit from small moves in the market and limits the number of winning trades you can make. At the same time, you become more likely to experience losses. Also, using leverage can put people in a dangerous position. Brokers can ask for a margin call if traders have a losing position. This call requires traders to put more money into their account, which may not always be possible. Leverage can amplify gains as well as losses. You might end up losing your entire investment.
The other point to keep in mind is that the lack of regulation can both benefit and harm you. You must do your due diligence on brokers to ensure they are reputable. In general, reputation and financial viability are the primary means of judging whether a broker is legitimate. This lack of regulation is part of the reason that CFDs are not available in the United States