Understanding CFD Financial Instruments

Contracts for Difference (CFD) are derivative financial trading instruments. With CFDs, you can speculate on rising or falling prices of rapidly moving financial instruments. These include treasuries, currencies, indices, commodities, and shares. It is possible to trade contracts for difference online with a fully regulated CFD brokerage. Take note that there is an element of risk when trading CFDs online, and that risk can encompass all of your trading capital. When leverage is involved, profits can be magnified, but so too can losses. It is important to ascertain the upside and downside potential of CFD trades before engaging in real-money trading.

How it works?

Unlike conventional trades in the stock market, no physical ownership of shares takes place. In other words, the CFD trader does not sell the underlying asset or buy the underlying asset. What is bought or sold however is a specific number of units of an underlying financial instrument, depending on whether the trader believes prices will rise or fall. CFDs are available on a multitude of products, including FX pairs (GBP/USD, USD/CAD, USD/ZAR, USD/EUR, GBP/EUR etc.), commodities (WTI crude oil, Brent crude oil, gold, silver), shares (Google, Facebook, Microsoft, Amazon etc.), indices (FTSE 100, CAC40, DAX 30, NASDAQ, Dow Jones, Nikkei 225 etc.), and treasuries. CFD instruments aggregate the up/down price movements of the stocks on indices, or currency movements, et al.

With CFD trading, it’s important to remember that the total position value is far greater than the margin requirement. Margin represents the percentage of the total position that traders need to put down to open a trade of that size. Typically, margin can be as low as 2% with CFD traders. This is known as trading on margin. CFD trades magnify your profits, but they can increase your losses since they are based on the total value of the CFD position. In other words, it is possible to lose far more than you invested in the CFD trade. Conversely, it is possible to gain far more than you invested when trades move in your favour.

What are the costs involved in CFD trading?

Evaluate all the costs in conventional stocks trading, and all the costs involved in CFD trading. For starters, most CFD brokers will charge a daily financing fee when trading contracts for difference. The exact charge will vary from broker to broker. Typically, most CFD brokerages are market makers. A market maker is responsible for determining the price of a contract for difference. Be advised that there are often differences between the price of the underlying financial instrument and the price it is offered by a CFD broker. Most of the time however, regulated, licensed and credible CFD brokers guarantee that their price will match that of the underlying financial instrument.

There also other types of costs involved with CFD brokers, notably Direct Market Access (DMA). With Direct Market Access CFD Brokers, there is a 100% guarantee that the underlying price of the financial asset on the markets will match that of the quoted price by the CFD broker. Naturally, professional CFD traders prefer direct market access providers. There is zero conflict of interest (zero divergence) between the broker and the trader with DMA CFD providers.

Besides the daily financing fee, there are other costs associated with CFD providers. These include fees for holding CFD positions overnight, the bid/offer spread, and commissions. Sometimes, there may be account management fees that need to be considered when trading CFDs. It is imperative that traders understand that commissions will be added to losing trades, and commissions will be taken from winning trades as well. To derive maximum benefit from trading CFDs, it’s important to evaluate all the fees and commissions at brokers.

Trade with Market Makers VS Direct Market Access (ECN systems)  

CFD market makers ‘make’ the prices of the underlying financial instruments. They will then use hedging to balance their risk with traders. It doesn’t matter what the actual price of the underlying financial instrument is, since the market makers are the market. Their pricing is used for buying/selling CFDs, and that’s all that matters. This lends itself to poor pricing vis-à-vis real market pricing, however it is justified given the additional risk and input provided by the CFD brokerage. Market maker CFD brokers can execute trades much quicker than real life markets, given that the CFD broker is the market maker.

Direct market access brokers (DMA) are operating in a transparent trading environment. This is true because the trading activity and the pricing is evident to anyone who is interested in that particular financial instrument (stocks, commodities, indices and currencies). When CFD trades are executed at a particular price, the direct market access broker has no part to play in it at all. The trade dovetails the performance of real life markets to a tee. DMA brokers make their money off commissions – they are the middlemen in the transaction. What this means in every day speak is that the price paid for a CFD is reflective of market rates. However, a counterparty is required to either buy or sell the asset, and this can delay the process.

CFDs Compared to Other Financial Instruments

Traders only require a small percentage of the total value of the transaction to trade CFDs. This is known as margin. CFDs also include leverage. Leverage varies from one broker to another, and can range from 1:50 up to 1:400 in most cases. The latest proposals by the FCA in the United Kingdom will have leverage capped at 1:50 for new traders and 1:100 for experienced traders, but this differs from one regulatory authority to another. Leverage can work for you or against you, depending on whether you finish in the money or out of the money. Small price changes can generate huge profits/losses depending on whether the trader speculates correctly or not.

New CFDs can easily be created provided there is sufficient demand from traders. Another important point to remember about CFDs is that they are OTC financial instruments. Over-the-counter trading does not require trading pits for buyers and sellers. There are no expiration dates on CFD contracts. This is a marked difference between CFD trading and options/futures trading. In all cases, it is imperative that traders conduct the necessary research and due diligence when selecting one CFD broker over another. A good idea is to use a demo trading platform to understand how CFDs work before depositing and trading for real money.