CFDs

CFDs: what they are and how they work

CFDs  (Contracts for Difference)  are derivative financial contracts that replicate the performance of another asset and allow you to invest against a Market Maker broker without ever passing through the underlying asset itself.

They represent a  complex  and particular instrument, which has had (and in all likelihood will continue to have) enormous success in Europe and Asia – in the  USA , however, it is banned from the  retail  market – because it allows  leverage  and, above all , access to different markets under the same conditions. Born as an instrument used mainly by  hedge funds , today CFDs are a financial product accessible to all and that can be used even by those who operate for the very first time on the markets.

What are CFDs

CFDs are derivative contracts that allow you to invest on margin, replicating the price trend of an underlying asset. They are derivative contracts and are typically traded outside official exchanges, therefore in OTC ( Over The Counter ) mode.

This is the “ scholastic ” and traditional definition, but for those who are not already experts in financial markets, it is quite difficult to understand. That’s why we want to start with the basics and see all their features in a simpler and more intuitive way.

CFDs are:

• Derivative contracts

Like  Futures  and  Options , contracts for difference are also derivative contracts. In fact, they do not involve the purchase or sale of the underlying asset, but simply of a security that replicates, with certain mechanisms, its value.

When we buy a  CFD  on Apple shares we are not actually buying Apple shares, but a contract between us and the broker, which follows the trend of the stock. In reality the mechanism is much more complex, at least behind the scenes, but we will get to that with the analysis of the other peculiarities of this contract.

• Suitable for margin investing 

CFDs are margin investing instruments. When we open a CFD position on  Amazon shares  for 1,000 USD, we do not have to pay the full amount, but only the margin to cover it. If we choose to trade without a margin, the coverage will necessarily have to be 1,000 USD. by choosing a margin of 50% – i.e. a 1:2 leverage – we will be able to cover the entire investment with 500 USD. If we choose 1:5 leverage – which is the maximum allowed in Europe, for example – we will only need to cover 20% of the position, in this case 200 USD.

Trading on margin allows you to invest more than what you have on your trading account

Different jurisdictions have  different rules on leverage . While in the United States it is not allowed to trade leveraged CFDs, in Europe it is possible to invest in stocks with a leverage of up to 1:5. In Australia, on the other hand, as well as in other countries it is possible to reach a leverage of 1:50 on stocks and even 1:200 on Forex.

• Replicate the price of the underlying asset

Throughout its lifetime, that is, until we decide to close the position, the CFD will  follow the trend  of the asset we want to, albeit indirectly, invest in. When we choose a CFD on Ethereum (yes, cryptocurrencies can also be hedged with CFDs), we get a price at the opening of the position, let’s imagine 350USD.

As the real value of  Ethereum  moves, the value “ carried ” by the contract also changes. For the performance of our capital, net of margin, holding a CFD or holding the underlying asset is virtually identical.

Minor differences can occur when the supply and demand for a certain financial instrument are very different between the exchange where the instrument is listed and the broker you are using to trade CFDs. Especially in very “ hot ” moments, such as after the Brexit referendum, it is difficult for a CFD to replicate the exact value of the underlying instrument moment by moment. The difference remains small in any case.

• Traded in OTC mode

CFDs  are typically  Over the Counter  instruments and they are not traded on regulated exchanges.  OTC  products are products that are not traded on a public exchange, but typically between the  dealing desk  (ie the broker) and the client. This means that the contract, being a derivative instrument, is between us who invests and the broker who has made the contract available to us.

Some states have tried to offer regulated markets to trade CFDs on the secondary market as well, imposing  draconian  regulations with the aim of making the market more transparent. However, very few have moved to this type of channel, mainly due to the obvious increase in transaction costs associated with such a solution.

The  OTC mode  can be a problem because it presupposes on the part of the investor full and total trust in the broker who also  acts as a  dealing desk . The CFD contract is literally a contract between two parties and there is no intermediary, state or otherwise, to standardize such contracts and above all to verify the solvency at any time of the contract in place.

A broker might sell you the  CFD  on a certain financial instrument, but no longer have the money to buy it when you decide to sell it. That’s why there are financial authorities, such as  ESMA  in the European Union,  FCA  in the UK and  ASIC  in Australia that oversee brokers. Their job is to make sure brokers remain solvent at all times and that they have insurance that covers their risk of insolvency.

CFD definition

“ CFDs ” stands for  Contracts for Difference .  The definition, however, aims to clarify only one of the fundamental aspects of this type of contract, namely that they are contracts that operate primarily on the  difference in price  between the current value of the underlying (the spot price) and the value at the time of closing the contract.

The most ignored part of the definition of CFD is the one related to the contract: we are in fact in front of a negotiation between two parties, that is between the broker and us. This contract is only between us and our broker: unlike real stocks, we cannot buy a CFD from a broker and then sell it to another person or another broker.

This feature of CFDs opens up several questions:

• They are not all exactly standard

As we mentioned, very small differences can occur between the market price and the  CFD price . Although most jurisdictions have regulations on this aspect, it is possible that two different brokers, at the same time, have two slightly different prices for the same  CFD .

• The broker is our counter party

And this is what the detractors of Contracts for Difference focus on the most. Because on the one hand the  broker  is technically betting against us and because on the other hand he has to be the one to honor the contract we have opened. We are not in the sea of ​​actual financial securities, where the security is worth owning and can be sold to third parties. CFDs only have value between us and the broker who issued them. They are precisely a  contract between two parties .

How CFDs Work

After having analyzed the didactic and scholastic parts of these contracts, we are ready to understand how the instrument in question works , especially in everyday practice on the financial markets.

Why can CFDs be a good alternative to what is offered by the direct purchase of securities ? Because they present particular characteristics that offer  operationalness and tools  that classic trading without derivatives and underlyings cannot offer.

• Investing on margins

It is very important, since the first appearance of this type of contracts. It should be remembered that CFDs have been widely used, especially by  hedge funds , because they allowed them to cover important positions with a  minimum capital commitment .

Leverage is as powerful as it is risky, because it allows you to technically invest capital that you do not have. The price difference on the leveraged investment, however, is  directly reflected  in the capital we have actually invested.

So if we invest €100 on EURUSD, with 1:30 leverage, we will be exposed to the market for €3,000. A variation of 3% in the value of the pair would mean a variation on our capital of 3% of €3,000, or €90. That would be 90% of the capital we have invested.

This can be very advantageous if the position we have opened is correct. We will almost double our investment with one trade and within a few hours. However, it is worth remembering that this  multiplication is valid both ways , ie even if our position should be negative. Following the example above, we would have lost 90%.

• Short positions

CFDs also allow you to  short-sell . All CFD brokers also offer this possibility, which allows you to bet on the  decline  of the underlying asset. Do we believe that Tesla shares will have a drop in the next few days? Well, we can buy a  sell or short contract  from a CFD broker and then close the position when the stock has lost enough value.

This possibility is impossible to achieve if not through the use of derivative contracts, of which CFDs are the most important representatives at least for those who access the markets on their own.

• Liquidity

When talking about the functioning of CFDs we must also talk about liquidity. Let’s talk about the market liquidity, that is the possibility of finding a useful counterpart for our purchase and sale. When markets are not very liquid, i.e. not very frequented by sellers and buyers, it becomes complicated to operate  on the spot , i.e. with the certainty that at any time we can get rid of the position we have opened.

With CFD contracts instead, this problem is solved upstream: our counterpart will always be the broker who sold us the contract. The OTC system presents risks because the failure of the broker would result in the futility of the contract.

However, in almost every country in the world, the  financial authorities  have set very clear rules against this type of eventuality. For example, the fact that client deposits must be kept in separate current accounts from company deposits. Brokers must also show their financial statements to the regulator on a regular basis to show that they have sufficient liquidity to operate. Finally, most jurisdictions provide for mandatory insurance. The risks are therefore minimal in terms of liquidity, with absolute advantages for those who choose this type of product.

• What happens when we buy a CFD

There is actually a lot going on behind the scenes when we buy a CFD, although from the investor’s side the process is one of the simplest you can imagine, as it does not vary, except in small ways, from what happens with the direct purchase of securities.

• FOR BUYERS : when buying a CFD, whether in a  long position  or  short position , we are deciding to buy a CFD, at a certain price level (which is the  spot  market price of the underlying asset), with a certain leverage for a certain amount of money.

When you buy a CFD, you are not buying the underlying asset as well

Practical example is buying $900 worth of NIO stock. From the moment we buy NIO it is trading at $45, so a contract with  1:1 leverage  will expose us to the value of about 20 shares. Instead if we choose to trade with  1:2 leverage , the contract will expose us to exactly twice as many shares, ie 40, and so on.

The following happens when the price of NIO changes: when the price changes, we will have to multiply the change and apply it to our real invested capital. If we had invested with a 1:2 leverage and the NIO were to rise by 3%, we would therefore have +3% x 2 = +6%. On the $900 we have invested this would be a gain of $54.

The process is identical for those who find themselves closing a position with a loss. A loss of 3% is to be multiplied by the leverage used and therefore by 2, in our example case, we would lose $45 out of $900 invested.

• FOR THE BROKER : the situation of the broker is much more complex, which can be skipped anyway for those who have no interest in understanding  how CFDs work  from both sides. The broker when opening a position is selling a contract, through which he commits to buying back the contract, resulting in the offsetting of any gains and any losses.

The contract it issues is valid only between the parties and with very rare exceptions – as for some brokers operating in the UK – it cannot be transferred to others via regulated markets. The broker to all effects is opening, contextually to ours, an inverse position. In case our investment is positive, the broker will settle it. In case our investment is negative, he will be the one to gain.

This type of functioning of CFDs is what makes them – according to the skeptics of these contracts – unreliable and not transparent. The reality is that this does not affect the investor much, since beyond his interests the broker has to undergo important obligations for the  exclusive protection of the investor  as required by law in almost all countries of the world.

How to invest in CFDs

Technically we do not invest in CFDs, but we use this tool to invest in the underlying assets that are represented . Today there are several brokers that allow us to go and invest using this instrument, although in the United States they cannot be traded. On the other hand, Europe, South Africa, Australia and Asia are markets where almost everywhere CFDs are fully legitimate and they are used by millions of investors.

Several brokers proposed a complete offer of products based on CFDs, allowing  neutral  access to all major markets. Therefore, it is enough to choose a good online trading  broker ( financial intermediary ) that offers this type of contracts to invest via CFDs, with the modalities,  caveats  and above all the tools we have listed above.  

O nline Trading in CFDs  /  Online Trading in CFDs

CFDs are instruments that allow you to trade by following both positive and negative trends. Their nature of derivative instruments in fact, allows a certain flexibility in decisions. In addition, they offer the possibility of using leverage.

Let’s start with the most classic position, the  long  one, which bets on the increase of the value of a certain asset. In this case  CFDs  behave in the same way as the direct purchase of securities. It will be enough to set a purchase order to have a derivative contract that will follow at every moment the official evaluation of the underlying instrument. In this case, closing the position we will have a gain in case the closing price is higher than the purchase price and vice versa.

In addition, it is possible through CFDs to short sell , ie to place on the market securities that we do not have in our portfolio and that are therefore “ slow ” to us by the broker. In this case we bet on the fall of the security, in an absolutely specular way to what we have seen with the  Long  position. Instead of trying to buy the securities at a low price to sell them at a high price, we will try to  sell them first  at a high price and then buy them at a lower price later.

Leverage plays an equally fundamental role in this mechanism: leverage in fact allows to  amplify the trend  of a security, creating a more pronounced volatility even on securities that are apparently very stable and on short-term movements of financial instruments.

This can be useful to those who want to trade in the  short term , but not only: also those who invest in long term positions could find the multiplication of the trend of the assets on which they have bet useful.

Investing in CFDs:  Pros and  Cons

Like all financial instruments, CFDs are not perfect. Their use is recommended when you want to make an investment of a speculative nature using leverage, also taking advantage of the possibility of selling short. Let’s see what their pros and cons are, when they can be useful and when they are not.

PROs of CFDs:

• Low limits for investing

CFDs, especially when they are traded on leverage, have the great advantage of being able to offer access even to those who want or can invest little. This allows you to build well-diversified portfolios even with a few hundred euros.

• Neutral access

There are no  preferred  markets for  CFDs . On the contrary, the structure of the contracts and the associated costs and commissions allow us to invest  neutrally  on all markets that may be of interest to us. This freedom cannot be guaranteed by any other instrument currently available on the markets and accessible even to those who are not millionaire investors.

• Short selling

We consider it to be an even more useful tool than leverage, which remains important when it comes to CFDs. Thanks to short-selling in fact it is possible to ride out negative trends that otherwise, in direct purchase mode, are impossible to exploit. However, there are also some  CONs of CFDs , which must be carefully evaluated before choosing this type of instrument for your trading operations:

• costs

By choosing unsuitable brokers it is possible to incur costs that are much higher than those of classic brokers. Overnight commissions are not always clear, even in this case when one does not use a correct and adequate trader.

• Inexperience

The possible use of tools such as leverage by inexperienced traders can result in significant losses. Of course, this is not the fault of CFDs, which simply provide a tool. The fact remains that those who are not able to control themselves or are thinking of approaching the markets without a precise strategy may be tempted by CFDs to take greater risks than necessary.

Is it worth trading CFDs?

Yes, we believe that CFDs are tools that effectively allow everyone to trade, at a very low cost and with access to markets otherwise beyond the reach of small investors.

It is undeniable that they are instruments of  absolute and total democracy  on the financial markets, offering the same opportunities both to those who invest significant capital and to those who do not have much to invest.

Of course, this does not mean that they are suitable instruments for everyone, but the fact that they are not  hyper-safe  instruments and that they shield the saver from any possible loss should not be misleading. Those who choose to  invest freely  and without the typical protections of managed savings, choose to run more risks but also choose to keep in their pockets the bulk of the commissions they would otherwise have to pay.

Characteristics of CFDs

There are some things that you need to know before you start investing in CFDs.  Let’s go through them one by one, while also comparing these characteristics peculiar to CFDs to what is offered by other financial assets.

Expiration of CFDs

CFDs have no expiration date, at least when the underlying asset is not subject to expiration.  When we invest therefore in Forex, Stocks, Commodities ( not in futures version ), Cryptocurrencies and ETFs the contract can absolutely be considered as perpetual.

The situation is different for those CFDs that instead have, as underlyings, securities with an  embedded maturity . This is the typical case of  futures , as well as bonds that can be traded through CFDs. All the best brokers offer a particularly clear prospect of the possible expiration of a CFD, thus allowing us to organize our trade taking into account this very precious information.

When a  CFD expires , if it is scheduled to expire, the position is  rolled over . The broker will automatically credit or debit the difference necessary to replace the just expired contract with an identical one, but with a future expiration.

CFDs: Costs and Commissions

CFDs are subject to two types of commissions that affect the cost of the contract both when buying and selling, and when a trade remains open from one day to the next.

In fact, all  CFD brokers  operate by applying a spread, which is the differential between the actual market price and the price charged on the platform. We will deal with this specific type of commission in CFD trading in a moment.

Then there are the overnight commissions, which are due for every position held open after the markets close. In this case, an annual interest rate is applied, divided on the day, to which a further (and small) spread is applied by the broker itself. All brokers report, at the moment of the order, a precise quantification of the quantity of overnight commissions that will be charged on the position.

CFD spreads

CFDs do not incur trading costs similar to the fixed costs we typically see when purchasing securities directly through bank brokers.  This of course does not mean that CFD brokers offer services completely free of charge. The commissions that are collected by brokers offering CFDs take the form of spreads, that is, the difference between the actual  spot  price on the market and the one we can find on the platform.

The following example may help to understand the actual scope of this type of commission. If the price of ENI on the stock exchange is 7.04 EUR for the purchase and 7.06 EUR for the sale, the broker tends to offer on his platform more divergent prices, in the form of 7.03 EUR and – always as an example – 7.06 for the salt. The difference between the real price and the price charged by the broker is called spread or differential.

Spreads can be fixed or variable, ie they can remain constant over time or be raised and lowered by the broker depending on market phases. Usually, brokers with variable spreads tend to raise them in moments of particular volatility: it is a way for the broker to protect himself and avoid exposing himself directly to easy gains by the client.

CFD assets

CFDs owe part of their popularity to the fact that they can have practically all asset classes available through the financial markets as underlying assets. You can invest via CFDs in:

• Forex

Forex trading  is largely done through CFD contracts, which allow not only to apply a maximum leverage of 1:30 on the main pairs, but also to have very convenient tools for  short  positions. Although technically we are used to considering this type of contracts as separate from CFDs, technically they are, and the same characteristics and commissions are applied to them as we are used to seeing for classic CFDs.

• Stocks

As far as trading in shares is concerned, CFDs have the enormous advantage over DMA purchases of being able to offer the investor neutral access to any type of market. Our reference is obviously to the overseas markets, on which, for clear and understandable reasons, bank brokers practice decidedly important commissions.

With CFDs, access is by the same means, whether you want to trade on a stock listed in Paris, in Hong Kong or in the USA. CFDs on equities have therefore offered many small investors the possibility of linking their investment to markets that were once inaccessible because they were prohibitively expensive and difficult to operate.

• Commodities s

Here, too, CFDs have played the role of making life easier for retail traders. Until the arrival of CFDs on the markets, it was practically impossible for small and medium-sized investors to trade on contracts which, dry, required minimum investments starting from lots of 100,000 USD.

CFDs, on the other hand, allow  fractional investment  even on this type of product, freeing up access for those who want to bet on oil, gold, natural gas but also on  soft commodities  without having large amounts of capital at their disposal.

• ETFS / ETFs

It might seem curious that passively managed funds, which often incorporate leverage, can be underlying CFDs . This actually shouldn’t come as a surprise to anyone who has tried trading CFDs on ETFs. Because we still have access to lower commissions and we can  take advantage  of leverage other than that which may be embedded in the security. Lastly, thanks to CFDs we can also sell short the value of an ETF.

• Cryptocurrencies

Investing in cryptocurrencies without resorting to CFDs presents major problems that must be taken seriously. Without CFDs, the only plausible alternative is cryptocurrency exchanges, virtual hubs that are often not registered as financial intermediaries and therefore offer far fewer guarantees.

In addition, CFD brokers charge on average much lower commissions, making investing via these contracts more profitable all-round than buying Bitcoin and altcoins directly.

• bonds

Bonds, a classic investment banking instrument, can also be traded via CFDs. The advantages in this case compared to the classic investment is certainly constituted by the possibility of  applying leverage , on products that tend to move very slowly at price. The bonds typically traded by CFD brokers are the American ones, with the possibility of sometimes also finding some European securities.

• Futures

Futures  are also products that are sometimes listed by CFD brokers. Futures are derivative contracts themselves, and it may seem counter-intuitive to buy a derivative on another derivative. Here again, the advantage may lie in what are the strongest pieces for CFD traders: lower transaction costs,  instant liquidity , and the ability to comfortably act short as well.

• Index

Almost all brokers that deal in CFDs deal in contracts that replicate the performance of a stock market index, as well as sometimes certain regional indexes or even baskets of assets, such as the VIX/VXX volatility index.

CFD’s, along with ETF’s, remain among the very few tools that a small or medium-sized investor has to trade these benchmarks, again, therefore, offering something practically unique in the investment scenario for independent traders and perhaps not with large amounts of capital to invest.

Trading in CFDs: actual opinions and reviews.

CFDs are investors instruments that can trigger very different reactions, even among the most experienced.  We will provide our version and opinions, which have matured over years on the markets (which have also included the use of instruments of this type), also indicating which may be additional sources of interesting and informed opinions.

Are CFDs a scam?

No, CFDs are not by their essence a scam: they are regular contracts, which are traded by plenty of more than legitimate brokers and which are also registered as legitimate traders in Europe, the UK, Australia and South Africa, much of Asia and South America.

Therefore, it is absolutely not possible to automatically associate CFDs with fraudulent schemes. However, as in almost all areas of the investment industry, there is a possibility that malicious parties may exploit the popularity of these specific securities to organize real scams.

Let’s start with the fact that since the 2000s CFDs have grown in popularity and today most investors, no matter how small or untrained, are familiar with them. Unfortunately, there are also brokers that are not registered in Europe – with fanciful offices in the Caribbean or Pacific islands – or even clones of legal brokers that offer (fake) CFD-style trading.

Therefore, if it is true that CFDs do not automatically mean scams, it is equally true that the fact that CFDs are present on a platform – whether real or fake – does not make you safe from possible scams. These are the most typical cases.

• CFDs used in the domain name

Most of the “brokers” with a website that includes the word CFD have, over time, almost always turned out to be  scams  – not exactly cleverly organized either. You can find fictitious names or names that follow those of regular brokers. Brokers operating outside the European borders

There are two types of offshore brokers: those that operate in legally respectable countries and therefore can be considered reliable and those that operate with offices – real or fictitious – in  tax and legal havens .

In both cases, it is better to avoid having any kind of relationship with those brokers who are not authorized in Europe. In the second scenario, we are most probably dealing with 100% fraudulent systems.

As with anything that may affect our assets, it is best to  be very cautious . Because the world is full of those who exploit the popularity of online trading and CFDs for fraudulent purposes, even if they are organized in criminal groups.