CFDs (derivatives) have been around for a while. We'd like to categorize these as more complex financial instruments. This article will give you an overview of some key things to know when it comes to trading CFDs.
Let's jump in!
CFD related terminology
CFD – a Contract for Difference is a popular financial derivative instrument (instruments whose value is derived from any underlying asset, which can include indices, commodities, currencies, equities, and more). CFD trading allows investors to speculate on the rise and the fall of volatile global markets without actually owning the underlying asset.
Initial margin – the minimum amount of money that is required to open a position.
Leverage trading – leverage is a concept that allows you to increase your exposure to a financial market without investing more cash. It can be used to profit from small price movements by having greater exposure to your capital.
Leverage ratio – is the amount of leverage provided by a broker to trade a leveraged product. The ratio usually is between 1:2 – 1:30.
Buying long – is when traders open a Contract for Difference position in expectations of a price increase. For example, when traders think that Apple’s (AAPL) price will increase, they are opening a long position.
Selling short – is when traders open a Contract for Difference position in expectations of a price decrease. For example, when traders think that Tesla’s (TSLA) price will go down, they are opening a short position.
Stop-loss (SL) – is a risk management order for investors and traders. Stop-loss is set by a trader at a specific price level at which the position is automatically closed in order to prevent additional losses. Stop-loss is recommended in every leveraged trade – it is generally considered mandatory.
Take profit (TP) – is an order to close a position at a specified rate if the market price increases, ensuring that your gain is realized and added to your available balance.
Balance - it is the amount of money that client transferred to the margin account, not including results of currently open positions.
Equity – the account equity including results of currently open positions, or the total value of margin account based on current market prices.
Margin – the amount of funds required to maintain open positions.
Free margin – account's free margin amount or funds that can be used to open more positions.
Margin call – an event where the value of your account falls below the predetermined threshold. To trade freely, you must have a sufficient free margin in your account.
Important note: In the EU there is a mandatory close out rule which standardizes the percentage of margin (at 50% of minimum required margin) at which providers are required to close out one or more retail client’s open CFDs. Read more from European Securities and Markets Authority.
What is a CFD?
A contract for difference (CFD) is a financial derivatives trading arrangement in which traders speculate on the movement of the price of an asset, without actually owning the underlying asset. CFDs do not involve the delivery of actual underlying, e.g. commodities or securities.
Simply put, a contract for difference (CFD) is a contract between a buyer and a seller in which the buyer agrees to pay the seller the difference between the current value of an item and its worth at the time of the transaction. CFDs enable traders and investors to profit from price movements without owning the underlying assets. The value of a CFD is determined solely by the price difference between the transaction entry and transaction exit.
It's a contract designed to profit from the difference in the price of a security between the opening and closing of the contract.
This is achieved through a contract between the customer and the broker; no stock, currency, commodity, or futures exchange is used. Trading CFDs provides many significant benefits for advanced investors. Over the past decade, CFD instruments have become increasingly popular.
Understanding contract for difference
When investing in stocks, bonds, or any other financial instrument, a trader will own the securities. CFD traders, on the other hand, do not hold any tangible assets. Instead, they trade on margin with units connected to a specific security price, based on its market value.
A CFD is the right to speculate on changes in the price of a security without actually having to purchase the security.
Leverage and exposure
The table is an example of leverages and exposure companies registered in the EU can offer to their customers – up to 30:1 leverage.
Companies registered in New Zealand and South Africa, for example, can offer up to 500:1 leverage trading options to their clients.
Example of a CFD trade
Martin is buying $11,500 worth of Apple stocks with the price of $115 per single share. He now has 100 Apple shares.
One month later, the stock price did reach $130. He then sold his 100 shares for $13,000, making a profit of $1,500.
The return of investment was a little bit over 13% of the initial amount invested.
Instead of just investing in Apple stocks, Martin now wants to leverage his trade to earn more money from that position. So he opens a long CFD position in Apple with 5:1 leverage.
Since the leverage is 5:1, Martin does not need to invest the whole $11,500 to get 100 shares of Apple stock. Instead, he uses the option of leverage and invests only $2,300 (11,500/5=2,300) in an Apple CFD. Now he has an open position size equivalent of 100 shares (without actually owning the shares). In other words, Martin gets the same exposure/position size with less initial capital.
One month later, the stock price peaked at $130, and Martin sold his long-position in an Apple CFD, making $1,500.
The return of investment was a little bit over 65% of the initial amount invested.
CFD trading is an excellent option for an experienced investor. Trading CFDs allows investors to allocate less initial capital to make the same returns as investing in stocks. It works the other way around as well – when a stock price is going the unwanted way, the losses are also amplified.
All CFD traders should use stop-losses, to prevent an exponential loss in capital.
Key things to know before trading CFDs?
- Trading CFDs with leverage should only be used by advanced traders, due to the amplified risk of margin trading.
- A contract for difference is an agreement between a trader and a CFD broker to exchange the difference in the value of a financial instrument between the opening and closing dates of the contract.
- A CFD investor never owns the underlying assets.
- A CFD investor earns/loses revenue based on the price change of the invested asset. For example, investors can speculate on the silver price movements when investing in a Silver CFD, and never own the asset.
- Traders can speculate on both ways – selling short or buying long.
- No expiry date of contracts.
- Less initial capital is needed.
- Possibility to earn higher returns.
- Risk of getting a margin call.
Pros and cons of CFDs
CFDs offer more leverage than traditional trading. Standard leverage depends heavily on CFD regulations, which change from time to time. For example, 50:1 leverage was once offered, meaning maintenance capital had to be only 2%. Today, however, it is limited to 30:1. The standard levels may be lowered even further in the future – maybe even to only 2:1.
According to Financefeeds European leverage limits are the following:
- 30:1 for major currency pairs (EUR/USD, GBP/USD, etc.)
- 20:1 for non-major currency pairs, gold, and major indices.
- 10:1 for commodities other than gold and non-major indices.
- 5:1 for individual equities.
- 2:1 for cryptocurrencies.
Interesting: In Australia, one can still trade forex with enormous leverage of 500:1
No shorting rules
Specific markets have rules that prohibit short selling or require the trader to borrow the instrument before selling short. However, CFDs can be short-sold at any time because the trader does not own the underlying asset.
Brokers offer stocks, indices, treasury, currency, and commodity CFDs. This allows speculative investors to trade in different markets and hedge their finances.
Can start with low amounts
CFDs offer leverage, allowing investors to use less initial capital.
Leveraged financial instruments are an excellent invention for traders to amplify financial gains. Unfortunately, leverage can also magnify losses.
Traders pay the spread
Traders pay spread from each position they take. During high volatility or fluctuations, the spread can be quite broad.
This is the interest that traders have to pay for holding a leveraged position overnight. It is calculated based on the CFD value and is deducted daily for every day the trader keeps the position open. The fee is not charged if the trader closes the position on the same day (before the overnight fee time).
Varying level of regulation
In many countries, the CFD industry is not highly regulated, which means traders rely on a broker’s credibility and reputation.
However, in the EU, the CFD industry is highly regulated and you can read more about the regulations from ESMA.
Margin call or liquidation
When trading with leverage, a margin call is possible. This results in significant losses in capital. Most times, traders can protect themself by setting stop-losses, but in extreme cases, even stop loss might not help.
CFDs vs. stocks
CFDs and regulations
CFD regulations are constantly changing and vary by region and country. In countries like the US and Hong Kong, CFD trading is prohibited.
In the United States, CFD trading is prohibited because it goes against the Securities Law – restrictions made by the Securities and Exchange Commission on over-the-counter financial instruments.
The Securities and Futures Commission of Hong Kong has forbidden CFD trading. However, Hong Kong residents can still trade CFDs via overseas brokers.
Countries with CFD bans are the USA, Hong Kong, Brazil. Interestingly the inhabitants of the last two countries can trade overseas, taking full responsibility for themselves.
Countries where only regulated firms are allowed to trade CFDs: China, Thailand, Malaysia, Albania, some Latin American and Arabic countries.
In the European Union, CFD trading is allowed, some restrictions and regulations vary a bit by country. For example, Belgium has prohibited some forms of CFD trading, such as Binary Options.
Most European CFD providers are regulated by The Cyprus Securities and Exchange Commission (CySEC). Service providers in the UK are regulated by The Financial Conduct Authority (FCA) in the United Kingdom.
The regulations of the regulatory authorities are mainly aimed at raising the awareness of traders to alleviate high-risk trading and protect traders’ capital and privacy.
CFD regulations are constantly changing. More CFDs will likely be regulated in the future to provide greater protection for traders.
In the United States, the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) have prohibited CFDs from being listed on regulated exchanges due to their high-risk nature.
FAQ of CFDs
Is it better to invest in stocks or CFDs?
Investing in stock shares has lower risk and fewer opportunities to earn. With stock shares investing, one can only make a profit when the underlying asset price increases. Trading with stock CFDs opens up opportunities to leverage trades and also short stocks.
One is not better than the other. Every investor and trader must analyse their risk tolerance and strategy to understand which options, as mentioned above, suit them better.
Which CFDs are available in the Change app?
The Change app is user-friendly for novice investors but also offers enough opportunities for advanced traders. In Change, assets can be traded and invested in. In addition, Change offers users the opportunity to invest in cryptocurrencies, stocks, commodities, and indices.
- Bitcoin (x2 leverage)
- Ethereum (x2 leverage)
- Gold (x20 leverage)
- Brent Oil (x10 leverage)
- Silver (x10 leverage)
- Nasdaq (x20 leverage)
- S&P 500 (x20 leverage)
US Stocks CFDs
- Tesla (5x leverage)
- Apple (5x leverage)
- Amazon (5x leverage)
- Facebook (5x leverage)
Why should I choose the Change app?
- Our team have worked hard to make the user interface very customer-friendly. It is effortless to buy, sell, and navigate in the app.
- We have a professional and fast support team.
- We are constantly developing new features in order for clients to have more variety and options.
- Straightforward, honest, and open communication with customers.
- We prioritize external communication to build a community, not a user base.
- We iterate based on user feedback to solve problems better.
- We benchmark against the industry and our competitors to understand how we’re doing and how to be better.
What are the costs of CFDs in Change?
Buying and selling CFDs in the Change app is commission-free. However, there are spread fees and overnight holding fees. Here is a small cheatsheet:
Minimum CFD spread
Overnight CFD fee
What is the smallest amount I can start with?
You can start investing already with €10.
Can I specify the leverage for my trades?
The leverages are fixed based on the asset you wish to trade.
Are you planning to add new assets?
Yes, we are constantly evolving and adding new assets to invest in and trade with
CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. The chances of loss from investing in CFDs can be substantial, and your investments' value may fluctuate. It would be best to consider whether you understand how this product works and whether you can afford to take the high risk of losing your money.
CFD Trading service is provided on a cross-border basis by Change Securities B.V. (Chamber of Commerce no. 50755854) located at De Hooge Krocht 2, 2201 TX Noordwijk, the Netherlands, authorised and regulated by the Dutch Authority for the Financial Markets (AFM).
Change Securities B.V. provides an execution-only service. The information in this site does not contain (and should not be construed as containing) investment advice or an investment recommendation, or an offer of or solicitation for a transaction in any financial instrument.
The information on this site is not directed at residents of the United States. It is not intended for distribution to or use by any person in any country or jurisdiction where such distribution or use would be contrary to local law or regulation.