Cfd trading define
In the late s CFDs were introduced to retail traders. They were popularized by a number of UK companies, characterized by innovative online trading platforms that made it easy to see live prices and trade in real time.
Around , retail traders realized that the real benefit of trading CFDs was not the exemption from tax but the ability to leverage any underlying instrument. This was the start of the growth phase in the use of CFDs. Trading index CFDs, such as the ones based on the major global indexes e. In the UK the CFD market mirrors the financial spread betting market and the products are in many ways the same.
However unlike CFDs, which have been exported to a number of different countries, spread betting, inasmuch as it relies on a country-specific tax advantage, has remained primarily a UK and Irish phenomenon. As a result, a small percentage of CFDs were traded through the Australian exchange during this period. The advantages and disadvantages of having an exchange traded CFD were similar for most financial products and meant reducing counterparty risk and increasing transparency but costs were higher.
In October , LCH. Within Europe, any provider based in any member country can offer the products to all member countries under MiFID and many of the European financial regulators responded with new rules on CFDs after the warning. The majority of providers are based in either Cyprus or the UK and both countries' financial regulators were first to respond. CySEC the Cyprus financial regulator, where many of the firms are registered, increased the regulations on CFDs by limiting the maximum leverage to The main risk is market risk , as contract for difference trading is designed to pay the difference between the opening price and the closing price of the underlying asset.
CFDs are traded on margin, and the leveraging effect of this increases the risk significantly. It is this very risk that drives the use of CFDs, either to speculate on movements in financial markets or to hedge existing positions in other products.
Users typically deposit an amount of money with the CFD provider to cover the margin and can lose much more than this deposit if the market moves against them. If prices move against open CFD position additional variation margin is required to maintain the margin level. The CFD provider may call upon the party to deposit additional sums to cover this, and in fast moving markets this may be at short notice.
Counterparty risk is associated with the financial stability or solvency of the counterparty to a contract. In the context of CFD contracts, if the counterparty to a contract fails to meet their financial obligations, the CFD may have little or no value regardless of the underlying instrument.
This means that a CFD trader could potentially incur severe losses, even if the underlying instrument moves in the desired direction. OTC CFD providers are required to segregate client funds protecting client balances in event of company default, but cases such as that of MF Global remind us that guarantees can be broken.
Exchange-traded contracts traded through a clearing house are generally believed to have less counterparty risk.
Ultimately, the degree of counterparty risk is defined by the credit risk of the counterparty, including the clearing house if applicable. There are a number of different financial instruments that have been used in the past to speculate on financial markets. These range from trading in physical shares either directly or via margin lending, to using derivatives such as futures, options or covered warrants. A number of brokers have been actively promoting CFDs as alternatives to all of these products.
The CFD market most resembles the futures and options market, the major differences being: Professionals prefer futures for indices and interest rate trading over CFDs as they are a mature product and are exchange traded. The main advantages of CFDs, compared to futures, is that contract sizes are smaller making it more accessible for small trader and pricing is more transparent. Futures contracts tend to only converge near to the expiry date compared to the price of the underlying instrument which does not occur on the CFD as it never expires and simply mirrors the underlying instrument.
Futures are often used by the CFD providers to hedge their own positions and many CFDs are written over futures as futures prices are easily obtainable. The industry practice is for the CFD provider to ' roll ' the CFD position to the next future period when the liquidity starts to dry in the last few days before expiry, thus creating a rolling CFD contract.
Options , like futures, are an established product that are exchange traded, centrally cleared and used by professionals.
Options, like futures, can be used to hedge risk or to take on risk to speculate. CFDs are only comparable in the latter case. An important disadvantage is that a CFD cannot be allowed to lapse, unlike an option. This means that the downside risk of a CFD is unlimited, whereas the most that can be lost on an option is the price of the option itself. In addition, no margin calls are made on options if the market moves against the trader. Compared to CFDs, option pricing is complex and has price decay when nearing expiry while CFDs prices simply mirror the underlying instrument.
CFDs cannot be used to reduce risk in the way that options can. Similar to options, covered warrants have become popular in recent years as a way of speculating cheaply on market movements. CFDs costs tend to be lower for short periods and have a much wider range of underlying products. In markets such as Singapore, some brokers have been heavily promoting CFDs as alternatives to covered warrants, and may have been partially responsible for the decline in volume of covered warrant there.
This is the traditional way to trade financial markets, this requires a relationship with a broker in each country, require paying broker fees and commissions and dealing with settlement process for that product. With the advent of discount brokers, this has become easier and cheaper, but can still be challenging for retail traders particularly if trading in overseas markets.
Without leverage this is capital intensive as all positions have to be fully funded. CFDs make it much easier to access global markets for much lower costs and much easier to move in and out of a position quickly.
All forms of margin trading involve financing costs, in effect the cost of borrowing the money for the whole position. Margin lending , also known as margin buying or leveraged equities , have all the same attributes as physical shares discussed earlier, but with the addition of leverage, which means like CFDs, futures, and options much less capital is required, but risks are increased.
The main benefits of CFD versus margin lending are that there are more underlying products, the margin rates are lower, and it is easy to go short. You can also use CFD trades to hedge an existing physical portfolio. You buy or sell a number of units for a particular instrument depending on whether you think prices will go up or down.
For every point the price of the instrument moves in your favour, you gain multiples of the number of CFD units you have bought or sold.
For every point the price moves against you, you will make a loss. Please remember that losses can exceed your deposits. Practise trading risk-free with virtual funds on our Next Generation platform. Open a demo account. CFDs are a leveraged product, which means that you only need to deposit a small percentage of the full value of the trade in order to open a position.
While trading on margin allows you to magnify your returns, your losses will also be magnified as they are based on the full value of the CFD position, meaning you could lose more than any capital deposited. When trading CFDs you must pay the spread , which is the difference between the buy and sell price.
You enter a buy trade using the buy price quoted and exit using the sell price. The narrower the spread, the less the price needs to move in your favour before you start to make a profit, or if the price moves against you, a loss.
We offer consistently competitive spreads. The holding cost can be positive or negative depending on the direction of your position and the applicable holding rate. View our market data fees. Commission only applicable for shares: View the examples below to see how to calculate commissions on share CFDs. CFD trades incur a commission charge when the trade is opened as well as when it is closed. The above calculation can be applied for a closing trade; the only difference is that you use the exit price rather than the entry price.
Learn more about CFD trading costs and commissions. Our spreads start from 0. You can also trade the UK and Germany 30 from 1 point and Gold from 0. See our range of markets. The spread is 2. You decide to close your buy trade by selling at pence the current sell price. The price has moved 10 pence in your favour, from pence the initial buy price or opening price to pence the current sell price or closing price.
You think the price is likely to continue dropping so, to limit your losses, you decide to sell at 93 pence the current sell price to close the trade.
The price has moved 7 pence against you, from pence the initial buy price to 93 pence the current sell price. View more CFD trading examples. CFD trading enables you to sell short an instrument if you believe it will fall in value, with the aim of profiting from the predicted downward price move. If your prediction turns out to be correct, you can buy the instrument back at a lower price to make a profit. If you are incorrect and the value rises, you will make a loss.
This loss can exceed your deposits. If you have already invested in an existing portfolio of physical shares with another broker and you think they may lose some of their value over the short term, you can hedge your physical shares using CFDs. By short selling the same shares as CFDs, you can try and make a profit from the short-term downtrend to offset any loss from your existing portfolio.