First things first: What are CFDs?

CFDs – short for “Contracts For Difference” – are a form of derivatives trading embraced by more and more casual investors. Of course, the word “derivatives” can have some spooky connotations – weren’t they what caused the financial crisis in 2008, after all? Well, yes and no. Complicated structured products like Mortgage-Backed Securities (MBS) ran into problems, but this did not and does not apply to simple derivatives like vanilla options or CFDs.

A CFD essentially means a client enters into a contract with a broker to trade the difference between market prices of an underlying asset at different points in time. This means that CFDs are a zero-sum game: one party gains what the other loses. 

The owner of a CFD can realise profits or losses when the underlying market moves. In this sense, CFDs are similar to futures contracts. There are, however, some significant differences, the most important of which is that CFDs never imply owning the underlying asset.

Why even use a derivative instead of just buying the underlying asset, you may ask? There are a number of advantages to CFDs that explain the huge surge in their use and popularity. 

CFDs in practice

Let’s go over a quick example trade.

A trader buys 50 CFDs based on Facebook stock when the share price is $170. Each CFD is worth 1 share, so the size of their position is $8,500. If the price rises by 20 dollars and they close out their position, they would make a $1,000 profit. If the price of Facebook shares has fallen 20 points at the time their position is closed, they would lose $1,000.

If actually buying Facebook shares through a traditional stockbroker, the client would need to put up all the funds involved. Alternatively, if their broker offers a 50% margin, the trade would require $4,250 in the investor’s account. A CFD broker, on the other hand, might only require a 5% margin, so this trade can be entered into using only $425 in real cash money.

Whatever kind of trading account you use for CFDs, there is always a bid/ask spread – the difference between the price you can buy and sell at. Traditional trading accounts charge a commission on top, costing you perhaps $10 per transaction. CFD brokers do not typically charge commissions but widen the bid/ask spread, perhaps by 0.1% each way.

Let’s take another example. 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 by €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, you would lose €500 once you close the trade.

Why, and why not, to trade CFDs

Ability to profit from rising and falling markets 

If you think the market is going up, then you can “go long”. Alternatively, if you think prices are about fall, you can “go short” with no extra expenses or administrative hassle. The cost and the ease of placing either trade are the same, unlike with long or short positions on actual equities.

Trade 24 hours a day 

Trading CFDs is a game that’s not confined to stock exchange hours, which are typically also the hours you spend at work. Out-of-hours markets allow trading at a time that suits your schedule.

Higher leverage 

CFDs require much less actual capital than traditional trading does. Generous leverage (or margin) helps to reduce the barrier to entry new traders, with less money available for trading, generally face. Using margin allows you to place bigger trades even with limited funds in your brokerage account, letting you compete with professional traders on a more equal footing. Of course, doing so amplifies potential profits and losses alike. It’s important not to get carried away, or you may end up owing your broker more than you initially deposited.

Trade multiple markets 

Only one account is needed to trade in all the major asset classes, including shares, stock indices, forex, bond and commodities markets, and ETFs. Online trading platforms and apps typically offer thousands of options, all right at your fingertips. 

Order types 

CFD trading allows you to place a number of trading orders to limit your exposure and maximise your profits. Stops, limits and contingent orders such as “One Cancels the Other” and “If Done” are all supported. Some brokerage platforms also offer guaranteed stops in return for paying a slightly wider spread.

No day trading requirements 

Certain markets, partly in order to curb excessive speculation, require day traders to possess minimum amounts of capital. However, those who choose to trade CFDs are not bound by the same restrictions. Depositing enough money to cover the margin is the only requirement.

No ownership 

CFDs avoid the headache of keeping certificates of ownership. Because you never actually own the securities, you have no voting rights or influence over the assets you are trading. On the other hand, the administrative burden is significantly lower. You will still earn dividends when trading shares CFDs, but only when you are holding a “long” position, i.e. doing the equivalent of buying a stock.

In conclusion

CFD trading offers a number of unique qualities that differentiate it from traditional investing techniques. Depending on your investing style and tolerance for risk, trading CFDs can be a very flexible and economical solution.

However, if your main goal is to grow your nest egg over the course of years, ideally without much active involvement on your part, bonds and equities are probably more your speed. Unless carefully managed, CFDs lose pretty much all their appeal, and those attractive margin/leverage requirements do entail the possibility of taking heavy losses.