Trading CFDs is incredibly easy. The instruments, which have the full title ‘Contracts For Difference’, allow clients of online brokers to attempt to make an investment return in markets including, equities, forex, commodities and cryptocurrencies.
You can trade CFDs without really knowing what they are, but getting a better understanding can make you a better trader. The topics that this article will cover are:
There's no getting away from the fact that the term ‘CFD’ is a piece of financial jargon. The good news is that scratching the surface offers an easy enough explanation of what CFD trading involves.
A CFD represents you and a broker agreeing to form a ‘contract' when you take a position in the market. Then when the position is closed out the ‘difference' between the entry and exit price will be represented as a profit or loss on your account.
If you buy one share in Tesla (Nasdaq:TSLA) for $420, then your return on the trade will obviously depend on what happens to the share price afterwards.
Tesla Share Price in the CFD market:
If it falls by $10 and you decide the risks associated with Elon Musk's venture are too great, and you sell your position (Sell Price A), then your account will be debited $10.
The alternative is that another positive news announcement takes the price to $460 when your profit on the trade would be $40. Selling your position at ‘Sell Price B’ would crystalise that gain and $40 would be credited to your account.
Your position size will act as a multiplier of the cash profit or loss that is made. If, as in the above examples, you had bought three shares of Tesla, the returns on the trades would have been $30 (3 x 10) and $120 (3 x 40), respectively.
To explain it a different way, CFDs are sometimes called a ‘wrapper'. The instrument you trade, the one on the broker's trading portal is Tesla stock ‘wrapped up' by them in a more convenient form.
You don't own the Tesla stock. Instead you have a binding contract with the broker, which will result in one of you paying the other depending on what happens to the price. The price used will be a function of the actual Tesla share price — the one sourced from the Nasdaq stock exchange.
One final point of clarification is that you don't need to sign a contract each time you trade. The onboarding process and agreement to the broker’s T&Cs covers you for any CFD trades you put on with them.
Another point to cover in terms of basics is realised and unrealised profit.
Taking the Tesla trade as an example, once the position is put on, the profit on it is ‘unrealised'. If price goes up your account will show a nice, usually green, positive number in the P&L column. If price falls below $420, that number will turn red and be negative.
You will only realise the profit when you decide to sell your position. Until then, it is a continually moving number in the P&L screen.
Put another way, if you buy a position in a CFD instrument and expect the value to double in 12 months, then, even if it at first drops in price, you won't realise any losses if you don't sell. If you wait and are correct, you can sell at that time and bank the gain you expected.
Or to put it another way — why don't the brokers offer the chance to buy the underlying, ‘real', instrument?
The short answer is that a lot of brokers do offer trading in both CFD and underlying formats.
The reality is that the historical reasons for CFDs being introduced in the first place were based on market anomalies. When firms and traders noticed the other benefits of trading in CFD formed a win-win situation, they became increasingly popular.
The CFD market appeared seemingly from nowhere in the early 1990s in London. It was developed to allow investors to take a position on UK listed stocks without paying the 0.25% SDRT tax on all share purchases.
Starting any trade 0.25% down is not ideal from the buyer's point of view, and due to the ‘synthetic wrapper' of CFDs that could be avoided.
It wasn't long until traders in the market latched on to the other advantages of trading in CFDs:
A glance at an online broker trading monitor shows how easy it is to buy or sell a position in the markets.
The below, taken from Pepperstone, shows the market for gold. It's possible to buy at $1,970.60 or sell for $1,970.30
Gold Price Chart — CFD on Pepperstone cTrader platform:
It's as easy as clicking on the direction of trade, entering your position size and confirming the transaction. There are more tools available to allow you to manage the risk on your position and your stop-losses. Take-profit instructions are also easy to get to grips with.
Note that it's not a requirement to have any gold already if you want to sell. Selling what you don't have already, a naked short, would follow the same mechanics as going long.
If you sell short one unit of gold at $1,970.30 and price falls to $1,960.30, then you would make a profit of $10. The reverse would be true if you sold short and the price then rose.
Before 1990, buying shares in a UK stock not only involved frictional costs associated with SDRT, but if you wanted to buy £10,000 worth of a stock, you needed £10,000. The CFD instrument broke this relationship and opened the door to a market revolution.
The broker UBS Warburg is largely credited with ‘inventing' CFDs. The firm's team that approached clients with the new product had an extra kicker to its proposition — leverage.
Warburg and other brokers quickly took advantage of the more sophisticated nature of CFDs to allow investors to trade in sizes larger than their capital had previously allowed.
Fineco Bank Leverage Terms:
Source: Fineco Bank
Traders were now able to put £10,000 with brokers as margin and to buy a multiple amount of their initial stake. Leverage of x10 meant that with the initial £10,000, traders could buy an asset costing £100,000. That meant the risk-return on the trade also increased x10.
This practice still applies today on retail as well as institutional accounts. Trading using leverage comes with added risks, but goes some way to explaining the popularity of the CFD market.
CFD trading is increasingly popular. The benefits in terms of trading experience and increased position size due to leverage have fed through as increased trade volumes. That, in turn, allows brokers to offer better pricing terms.
The bid-ask (buying – selling) spread is dependent mainly on liquidity. The more liquid a market, the tighter the spread.
The broking sector is very competitive, so to attract customers, the difference between their respective bid-ask prices narrowed. That resulted in reduced costs for investors and increased business for brokers.
Source: Fineco Bank
Those traders who still hanker after holding the underlying in physical form can take some comfort. There are many ways to take a position that doesn't require a CFD wrapper. Most brokers offer both services to ensure they cater for client demand. It's just that, for most, CFD trading is the preferred option.
The mechanics of CFDs all take place beneath the surface. As a trader you'll see brokers offering you a buy and sell price (the bid-offer spread) and the option to enter the amount you want to trade and whether you want to buy and sell.
In terms of making a profit, it's probably worth parking the knowledge you have about the processes involved to one side. The free research, trading ideas and risk management advice offered is possibly going to have a more significant impact on your trading P&L.