CFD Trading – what is it?

So, what is CFD Trading? When thinking of investing or trading, purchasing straightforward equities likely comes to mind for most folks. For those looking to venture outside traditional investment paths, CFDs or ‘contracts for difference’, are a viable option, offering unparalleled opportunities in today’s global markets.

Presented as leveraged products, CFDs quote via bid (a value traders can sell at) and ask (a value traders can buy at) prices. Additional benefits include the choice of trading both long and short positions (buy/sell) and, for UK residents, CFD traders avoid paying stamp duty tax.

It is important to remember, though, unlike the equity market, CFDs are derivatives designed to mirror underlying price movement. As a result, you’ll never own the underlier.

A bit of history

Popularised by a number of UK companies, CFD products entered the retail derivative domain in the late 1990s, allowing clients to sell markets while using leverage. CFDs, according to research, were originally developed by a London derivative brokerage firm called Smith New Court.

It wasn’t until around the year 2000, nevertheless, did CFDs witness notable growth. CFD providers, also known as brokers or dealers (the term is interchangeable), expanded their offering from the London Stock Exchange shares to include indices, global stocks, bonds, commodities and currencies. Indices quickly became the most popular form of CFDs.

CFDs vs. options and futures

Although CFDs, options and futures are all derivative products and, in simple form, represent an agreement between two parties, each market possesses notable differences.

An option contract is an agreement providing the option buyer the right, but not the obligation, to buy (a call option) the underlying asset at a strike price on a specific future date, known as the expiration date. An option writer, who sells a call option, on the other hand, takes on the obligation to sell the underlying asset to the buyer, should the buyer decide to exercise the option.

A futures contract is an agreement to buy or sell a particular asset at a predetermined price at a specified time in the future, also known as the expiration date.

Options and futures contracts are normally traded through exchanges (Chicago Board Options Exchange [CBOE] and Chicago Board of Trade [CBOT]), whereas CFDs tend to trade over the counter, or OTC (not channelised via any centralised exchange). CFDs operate through a network connecting various banks, dealers, and brokers.

Unlike options and futures, CFD products typically have no expiry. A contract for difference trade closes at the end of each trading day and is ‘rolled forward’, meaning (assuming you have the funds) you can effectively keep your position open indefinitely.

CFD Trading Leverage

CFDs trade on margin. Margin is the amount of money needed as a deposit in order to open a position with your broker. Margin requirements vary from instrument to instrument and can be changed at any time to reflect market conditions. 

Leveraged trading permits you to trade larger amounts than you normally could. In essence, it offers the ability to control a large sum of capital using very little of your own funds. Trading CFDs with leverage is straightforward, though can be considered high risk if not controlled accordingly. For every $1 in your account you can control $X amount where X is greater than 1. For instance, 1:100 leverage means you control $100 for each $1 in your account. If you have $1,000 in your account this means you can control $100,000 in positions.

For newer traders, avoiding highly leveraged positions is advised.

CFD Trading example

Say the AUS200 index is oversold and ripe for a long trade.

Market price currently trades at 4950.00/4951.00.
One contract equates to a $1 per index point.
No commission on indices.

The trader goes ahead and buys five contracts at 4951.00 (the ask price). In this example the point value equals $5. Price moves in favour and rallies to the set take-profit target at a closing price of 4990.00/4991.00. The outcome of this trade, therefore, equals a 39-point gain from this CFD position:

$5 per point.
Entry price of 4951.00.
Exit price of 4990.00.
Total profit = 39 points, or $195 gross profit (39 points * 5 contracts).

To calculate the net profit, however, you must include any financing or dividend adjustments. Financing adjustments are applied to Indices daily. In the case of a buy trade, interest is debited from the trader’s account, and with a sell trade interest is credited. Dividend adjustments are also applied whenever a stock in the relevant index goes ex-dividend.