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Table of ContentsWhat Is a Contract for Differences (CFD)? How CFDs Work Countries Where You Can Trade CFDs Costs Advantages Disadvantages Example FAQs The Bottom Line
By CORY MITCHELL, Updated June 22, 2023
Reviewed by MARGUERITA CHENG
Fact checked by PETE RATHBURN
A contract for differences (CFD) is a contract between a buyer and a seller that stipulates that the buyer must pay the seller the difference between the current value of an asset and its value at contract time.
How Contracts for Differences (CFDs) Work
A contract for differences (CFD) is an agreement between an investor and a CFD broker to exchange the difference in the value of a financial product (securities or derivatives) between the time the contract opens and closes.
CFDs are not allowed in the United States. They are allowed in listed, over-the-counter (OTC) markets in many major trading countries, including the United Kingdom, Australia, Germany, Switzerland, Singapore, Spain, France, South Africa, Canada, New Zealand, Sweden, Norway, Italy, Thailand, Belgium, Denmark, and the Netherlands, as well as the Hong Kong special administrative region..
The U.S. Securities and Exchange Commission (SEC) has restricted the trading of CFDs in the U.S., but nonresidents can trade using them.
Important: As worldwide equities markets tumbled in 2022, investor interest in CFD trading also declined. A downturn in Google searches related to CFDs reflected the lower levels of engagement with the trading strategy. Declines in trading revenue by brokerage firms that offer CFD trading also signaled this downswing
The costs of trading CFDs include a commission (in some cases), a financing cost (in certain situations), and the spread—the difference between the bid price (purchase price) and the offer price at the time you trade.
For example, suppose that a trader wants to buy CFDs for the share price of GlaxoSmithKline. The trader places a £10,000 trade. The current price of GlaxoSmithKline is £23.50. The trader expects that the share price will increase to £24.80 per share. The bid-offer spread is 24.80–23.50.
CFDs provide higher leverage than traditional trading. Standard leverage in the CFD market is subject to regulation. It once was as low as a 2% maintenance margin (50:1 leverage) but is now limited to a range of 3% (30:1 leverage) and could go up to 50% (2:1 leverage). Lower margin requirements mean less capital outlay for the trader and greater potential returns; however, increased leverage can also magnify a trader’s losses.
Global Market Access From One Platform
Many CFD brokers offer products in all of the world’s major markets, allowing around-the-clock access. Investors can trade CFDs on a wide range of worldwide markets.
No Shorting Rules or Borrowing Stock
Certain markets have rules that prohibit shorting, require the trader to borrow the instrument before selling short, or have different margin requirements for short and long positions. CFD instruments can be shorted at any time without borrowing costs because the trader doesn’t own the underlying asset.
Professional Execution With No Fees
CFD brokers offer many of the same order types as traditional brokers, including stops, limits, and contingent orders, such as “one cancels the other” and “if done.” Some brokers offering guaranteed stops will charge a fee for the service or recoup costs in another way.
No Day Trading Requirements
Certain markets require minimum amounts of capital to day trade or place limits on the number of day trades that can be made within certain accounts. The CFD market is not bound by these restrictions, and all account holders can day trade if they wish. Accounts can often be opened for as little as $1,000, although $2,000 and $5,000 are common minimum deposit requirements.
Variety of Trading Opportunities
Brokers currently offer stock, index, treasury, currency, sector, and commodity CFDs. This enables speculators interested in diverse financial vehicles to trade CFDs as an alternative to exchanges.
Traders Pay the Spread
While CFDs offer an attractive alternative to traditional markets, they also present potential pitfalls. For one, having to pay the spread on entries and exits eliminates the potential to profit from small moves.
Weak Industry Regulation
The CFD industry is not highly regulated. A CFD broker’s credibility is based on reputation, longevity, and financial position rather than government standing or liquidity. There are excellent CFD brokers, but it’s important to investigate a broker’s background before opening an account.
CFD trading is fast-moving and requires close monitoring. As a result, traders should be aware of the significant risks when trading CFDs. There are liquidity risks and margins that you need to maintain; if you cannot cover reductions in values, then your provider may close your position, and you’ll have to meet the loss no matter what subsequently happens to the underlying asset.
Important: Because the industry is not regulated and there are significant risks involved, CFDs are banned in the U.S. by the Securities and Exchange Commission (SEC)
Suppose that a stock has an ask price of $25.26 and the trader buys 100 shares. The cost of the transaction is $2,526 (plus any commission and fees). This trade requires at least $1,263 in free cash at a traditional broker in a 50% margin account, while a CFD broker requires just a 5% margin, or $126.30.
A CFD trade will show a loss equal to the size of the spread at the time of the transaction. If the spread is 5 cents, the stock needs to gain 5 cents for the position to hit the breakeven price. While you’ll see a 5-cent gain if you owned the stock outright, you would have also paid a commission and incurred a larger capital outlay.
If the stock rallies to a bid price of $25.76 in a traditional broker account, it can be sold for a $50 gain or $50/$1,263 = 3.95% profit; however, when the national exchange reaches this price, the CFD bid price may only be $25.74. The CFD profit will be lower because the trader must exit at the bid price and the spread is larger than on the regular market.
In this example, the CFD trader earns an estimated $48 or $48/$126.30 = 38% return on investment. The CFD broker may also require the trader to buy at a higher initial price—$25.28, for example. Even so, the $46 to $48 earned on the CFD trade denotes a net profit, while the $50 profit from owning the stock outright doesn’t include commissions or other fees. Thus, the CFD trader ends up with more money in their pocket.
How Do CFDs Work?
A contract for difference (CFD) allows traders to speculate on the future market movements of an underlying asset, without actually owning or taking physical delivery of the underlying asset. CFDs are available for a range of underlying assets, such as shares, commodities, and foreign exchange.
What Are Contracts for Differences (CFDs)?
Contracts for differences (CFDs) are contracts between investors and financial institutions in which investors take a position on the future value of an asset. The difference between the open and closing trade prices are cash-settled. There is no physical delivery of goods or securities; a client and the broker exchange the difference in the initial price of the trade and its value when the trade is unwound or reversed.
Why Are CFDs Illegal in the U.S.?
Part of the reason why a CFD is illegal in the U.S. is that it is an over-the-counter (OTC) product, which means that it doesn't pass through regulated exchanges. Using leverage also allows for the possibility of larger losses and is a concern for regulators.
Can You Make Money With CFDs?
Yes, it is possible to make money trading CFDs; however, trading CFDs is a risky strategy relative to other forms of trading. Most successful CFD traders are veteran traders with a wealth of experience and tactical acumen.
Advantages to CFD trading include lower margin requirements, easy access to global markets, no shorting or day trading rules, and little or no fees; however, high leverage magnifies losses when they occur, and having to pay a spread to enter and exit positions can be costly when large price movements do not occur. Indeed, the European Securities and Markets Authority (ESMA) has placed restrictions on CFDs to protect retail investors