Contract for Differences (CFDs) Overview
What are CFDs?
CFDs – short for "Contract For Difference" are a form of derivatives trading.
CFDs are contracts between investors and financial institutions (CFDs broker) in which investors take a position on the future value of an asset. The difference between the open and closing trade prices are cash-settled. There is no physical delivery of goods or securities; a client and the broker exchange the difference in the initial price of the trade and its value when the trade is unwound or reversed.
A CFD investor never actually owns the underlying asset but instead receives revenue based on the price change of that asset.
How Do CFDs Work?
A contract for difference (CFD) allows traders to speculate on the future market movements of an underlying asset, without actually owning or taking physical delivery of the underlying asset. CFDs are available for a range of underlying assets, such as shares, commodities, and foreign exchange.
A CFD involves two trades.
- The first trade creates the open position, which is later closed out through a reverse trade with the CFD provider at a different price
- If the first trade is a buy or long position, the second trade (which closes the open position) is a sell. If the opening trade was a sell or short position, the closing trade is a buy.
The net profit of the trader is the price difference between the opening trade and the closing-out trade (less any commission or interest).
Essentially, investors can use CFDs to make bets about whether or not the price of the underlying asset or security will rise or fall. Traders can bet on either upward or downward movement.
- If the trader that has purchased a CFD sees the asset's price increase, they will offer their holding for sale. The net difference between the purchase price and the sale price are netted together. The net difference representing the gain from the trades is settled through the investor's brokerage account
- On the other hand, if the trader believes that the asset's value will decline, an opening sell position can be placed. In order to close the position, the trader must purchase an offsetting trade. Then, the net difference of the loss is cash-settled through their account.
Why Are CFDs Illegal in the US?
Part of the reason that CFDs are illegal in the U.S. is that they are an over-the-counter (OTC) product, which means that they don't pass through regulated exchanges.
Using leverage also allows for the possibility of larger losses and is a concern for regulators.
CFDs are allowed in listed, over-the-counter (OTC) markets in many major trading countries, including the United Kingdom, Germany, Switzerland, Singapore, Spain, France, South Africa, Canada, New Zealand, Hong Kong, Sweden, Norway, Italy, Thailand, Belgium, Denmark, and the Netherlands. 1
Example of a CFD Trade
The costs of trading CFDs include a commission (in some cases), a financing cost (in certain situations), and the spread—the difference between the bid price (purchase price) and the offer price at the time you trade.
For example, suppose that a trader wants to buy CFDs for the share price of GlaxoSmithKline.
- The trader places a £10,000 trade. The current price of GlaxoSmithKline is £23.50. The trader expects that the share price will increase to £24.80 per share. The bid-offer spread is 24.80-23.50.
- The trader will pay a 0.1% commission on opening the position and another 0.1% when the position is closed. For a long position, the trader will be charged a financing charge overnight (normally the LIBOR interest rate plus 2.5%).
- The trader buys 426 contracts at £23.50 per share, so their trading position is £10,011. Suppose that the share price of GlaxoSmithKline increases to £24.80 in 16 days. The initial value of the trade is £10,011 but the final value is £10,564.80.
- The trader's profit (before charges and commission) is as follows: £10,564.80 – £10,011= £553.80
- Since the commission is 0.1%, upon opening the position the trader pays £10. Suppose that interest charges are 7.5%, which must be paid on each of the 16 days that the trader holds the position. (426 x £23.50 x 0.075/365 = £2.06. Since the position is open for 16 days, the total charge is 16 x £2.06 = £32.89.)
- When the position is closed, the trader must pay another 0.01% commission fee of £10.
- The trader's net profit is equal to profits minus charges: 553.80 (profit) – 10 (commission) – 32.89 (interest) – 10 (commission)= £500.91 (net profit)
Suppose that a stock has an ask price of $25.26 and the trader buys 100 shares. The cost of the transaction is $2,526 (plus any 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 $0.05 cents, the stock needs to gain $0.05 cents for the position to hit the break-even price. While you'll see a $0.05 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.
An investor wants to buy a CFD on the SPDR S&P 500 (SPY), which is an exchange traded fund that tracks the S&P 500 Index. The broker requires 5% down for the trade.
- The investor buys 100 shares of the SPY for $250 per share for a $25,000 position from which only 5% or $1,250 is paid initially to the broker
- Two months later the SPY is trading at $300 per share, and the trader exits the position with a profit of $50 per share or $5,000 in total
- The CFD is cash-settled; the initial position of $25,000 and the closing position of $30,000 ($300 * 100 shares) are netted out, and the gain of $5,000 is credited to the investor's account.
A trader buys 50 CFDs of Facebook when the share price is $170. Each CFD is worth 1 share so the size of your position is $8,500.
- If the price rises 20 dollars and you close out your position, you would make a $1000 profit. If the price of Facebook shares falls 20 points, once your position is closed, you would lose $1000.
- With a traditional stockbroker, the client would need all the funds or, using a 50% margin, the trade would require $4,250 in the account. A CFD broker might only require a 5% margin so this trade can be entered using of only $425.
You sell 0.5 CFDs of the ‘Germany 30’ index at €12,000. Each CFD is worth 10 times the index price so the size of your trade is €60,000.
- If the price falls €100 to €11,900, and you close the trade, you make €500 in profit.
- If however, you sell 5 CFDs of ‘Germany 30’ at €12,000 and the price rises by 100 points, once you close the trade, you would lose €500.
Finance Magnates. "Where Brokers Can Offer CFDs Around the World – Regulations Breakdown."˄