What Are CFDs? Contracts for Difference Explained

Contracts for Difference, or CFDs, are a way for traders to participate in the financial markets. They usually require less capital than buying traditional stocks, currencies, or cryptocurrencies.

What Are CFDs?

CFD stands for Contract for Difference. It is a financial derivative product allowing traders to speculate on the price movements of various financial assets such as stocks, indices, currencies, and commodities without owning the underlying asset.

When you trade a CFD, you enter into a contract with a broker to exchange the profit or loss based on the price difference between when the trade is opened and closed. If you think the price of the asset will go up, you can open a long position or buy the contract; if you think the price will go down, you can open a short position or sell the contract.

It is very similar to buying the actual asset. For example, you could buy Apple Inc. (AAPL) stock and you own it, or you could buy a CFD of AAPL. The CFD will move the same as the underlying AAPL stock. The main difference is that with the CFD you don’t actually own the stock. With the CFD you simply make or lose money based on where the price moves relative to your entry point.

If you buy a CFD for 10 shares of AAPL at $145, and the price increases to $155 and you close the position, you made $100 (10 shares x $10 profit per share). In the “Costs” section later on we’ll look at how profits vary between CFDs and traditional markets.

How CFDs Differ From Traditional Markets

Stocks, currencies, bonds, and cryptocurrencies are all traditional markets: when you take a position, you own that asset until you sell it.

You can trade a CFD on any of these markets, but you don’t own anything with the CFD. A CFD is more like a wager between you and the broker on the direction the asset will go.

CFDs have several advantages and disadvantages compared to traditional forms of trading. By “traditional”, I’m referring to buying a stock on the stock exchange versus buying a stock CFD, or buying Bitcoin directly compared to buying a Bitcoin CFD.

Go Long or Short Whenever You Want

CFDs allow traders to take advantage of price movements in both directions, providing opportunities for profit in both rising and falling markets. Traditional markets provide this as well, although there may be some restrictions. For example, some stocks on the stock exchange aren’t shortable, but you may be able to short them with a CFD.

A disadvantage though is that CFDs are not offered on all traditional markets and products. There is typically only a small selection offered for CFD trading.

Higher Leverage

CFDs also offer higher leverage than traditional trading, meaning you can trade with a smaller amount of capital. This can be both good and bad. With effective risk management, it can be beneficial. Without risk management, however, money can be lost quickly on losing trades.

Larger Spreads and Higher Fees

CFDs often have higher fees than traditional markets. CFD brokers increase the spread, the difference in price between where you can buy and sell, compared to traditional markets. This acts as a cost.

CFDs also have an overnight holding charge, which is essentially paying interest on the position. This means CFDs are primarily used for short-term trading, as the interest paid on the CFD cuts into returns. Traditional markets are better for holding positions over the long-term).

One Counterparty

When you buy the stock, you could be buying from anyone in the world. When you buy a CFD you enter into a direct contract with your broker. You are buying from and selling to them, and only them (in nearly all cases).

No Day Trading Rules

In the US, day traders are required to have $25,000 or more in their account if they want to day trade stocks. This rule does not apply to other markets or countries, and CFDs likewise have no such restrictions.

Why Do Brokers Offer CFDs?

If a CFD is just a replica of the underlying asset, and tracks its price movements, why do brokers offer CFDs? Why not just offer trading on traditional markets?

CFD trading is profitable for brokers. They can create their own fees, make their own spread, and can offer you more leverage than traditional markets offer. Traditional markets are under strict regulations by local authorities, but CFDs are much less regulated.

CFDs are also much easier for the broker to manage. They don’t need to send a client’s money to another person when the stock is bought (like in traditional markets). The CFD broker is the counterparty to every transaction. It collects profits when clients lose and pays out clients that win. It also collects money from overnight holding costs and commission fees.

International brokers may also not have the infrastructure to connect to various traditional exchanges around the world (and adhere to their laws), but they can simply replicate the products offered and then offer them to clients.

Where are CFDs Legal?

CFDs are not legal in all countries. Some countries have banned them, some countries regulate them, and some countries have no laws pertaining to CFDs.

Contracts for Difference are not legal in the US or Brazil. CFDs are legal in Canada, the U.K., and most other countries. While CFDs are legal in most countries, the rules related to them can vary substantially. If you are going to trade CFDs, look up the regulations in your region.

CFD Trade Examples

Here are examples of the costs and profits associated with several CFD trade scenarios.

Let’s assume you are a day trader and you buy 10 shares of Tesla Inc. (TSLA) at $195. You sell them later in the day at $198. There are no overnight holdings costs because the position is not held overnight – but there are often commissions that will be charged.

CMC Markets, for example, charges $0.01 per share, with a minimum commission of $8 (may vary by location). The profit on the trade is therefore $22 [((198 – 195) x 10) – $8]. This is similar to traditional markets, and the profit will vary based on the commission paid.

Now, assume a swing trader buys 10 shares of Tesla at $195 and you get out at $220. The trade lasts 10 days. There is still an $8 commission. The profit is $242 [((220 – 195) x 10) – $8] but this does not account for overnight holding costs. For example, CMC’s holdings costs are currently 0.0193% per day (subject to change as interest rates change).

The value of the position is $195 x 10 = 1950. Therefore, the daily cost is 0.0193% x 1950 = $0.37635 per day. The position is held for 10 days. Therefore, holding costs are $3.76. This reduces the profit from $242 to $238.24

What About the Spread?

CFD brokers that charge a commission tend to have tighter spreads than CFD brokers that don’t. Spreads vary by broker. The spread is a cost to take into consideration because it affects our profits and losses in actual trading.

Let’s take a look at how that might play out. In the traditional market, there is a minimal spread on Tesla shares, so if the offer price is $195, you can get in there.

With a CFD broker, if the offer price in the traditional market is $195, the offer price with the CFD may be $195.25. Therefore, you need to decide whether you’ll wait to see if your market price drops so you can get in at $195 with the CFD broker, or if you will enter at $195.25 – higher than you could get in with the traditional market.

The same happens on the sell. The stock market may show a price of $198, but the CFD broker shows a price of $197.75. You either need to wait for the price to rise more to get out at $198 with your CFD broker, or you sell at $197.75 for less profit.

The spread does affect profits in actual trading because the price needs to move more with a CFD in order for you to make the same profit you would on the same position in the traditional market (buying the actual shares).

For reference, CMC’s spread on Tesla shares is usually around $0.04, whereas in the actual stock market the spread will fluctuate around $0.02 (this varies by time of day, volume that day, volatility, and other factors). CFD brokers that don’t charge a commission may charge a much higher spread, such as $0.25 or $0.50 on a stock like Tesla.

Look for brokers with small spreads, because it becomes much harder to trade with larger spreads. A minimum commission charge can also hurt a small account. If you are only buying $100 worth for a product and you pay $8 in commissions, for example, you are instantly down 8%.