The acronym CFD stands for ‘Contract For Difference’, which means that buyers (or sellers) will be paid based on the price movement by their counterparty. Unlike trading in traditional financial instruments, CFD’s are a contract between two parties, and there is no ownership implied or realised by the transaction.

CFD’s are almost exclusively designed for short-term speculation or short-term hedging purposes. Counterparty risk is also a consideration when trading CFD’s, as a CFD is only worth as much as the entity that writes it.

How does CFD trading work?

The best Australian explanation comes from Andrew Templer from ASIC, and if this is new to you, its a great way to spend 3 minutes.

The basics of CFD trading are straightforward.  Traders enter a position by buying or selling a contract that is tied to an underlying instrument at a given level, which is determined by the market maker they are trading.

For example, CFD’s are commonly written for major Forex pairs, equity indices, interest rates for widely traded debt instruments, commodities and some other popular financial products.

Unlike buying the financial instruments themselves, CFD trading usually allows an investor to gain exposure to the underlying instrument at a much lower cost.

When buying equities on a margin, it is rare that 100% leverage is offered. More limited leverage means that if an investor wants to gain exposure to $10,000 worth of shares, they will need almost $5,600 of capital to buy into the position, assuming they can leverage 80% of the principle.

With CFD’s the leverage available is generally over 100x (equal to 10,000% of the principle), so that same $10,000 position would only require $100 to open. Lower initial investments can be both advantageous and dangerous, depending on how that leverage is used.

Example 1: Forex CFDs

CFD’s are nearly always traded based on a spread that the market-maker/dealer creates.

For example, let’s say that the USD/AUD is trading at 1.3020/1.3040 so a trader can buy the pair at 1.3020, or sell it at 1.3040. The difference between the two prices is called the ‘spread,’ and when you trade CFD’s, the size of the spread is important.

In this case, you choose to buy $50,000 worth of the contract at 1.3020, as you are speculating that the USD will rise in price versus the AUD. If your broker requires a margin of .2%, this trade will cost you $100 to open, though your risk isn’t limited to the initial margin that is necessary.

Let’s suppose that over the next two days the trade moves in your favour and the price of the USD rises to 1.3100, or a gain of 80 points on the contract. Your profit would be [$50,000 x 1.3100] 65,500 – [$50,000 x 1.3020] 65,100, or $400.

The profit would represent a gain of 400% on the initial margin required to open the trade, and demonstrates why so many traders want to employ leverage.

But using large amounts of borrowed money in a position is also risky.  Should the market go against you, your position can end up losing a lot of value quickly.

Example 2: Stock CFDs

Let’s suppose that you think that the S&P 500 is going to rally on a better than expected GDP report. The index is trading at 2637.38/2636.88 with your CFD broker, with the buying price first, and the selling price second.

Because you think the index will rally, you buy three CFD contracts at 2637.38, with a margin requirement of 1%. Your broker will assign a value to the index points for any given security, but for this example, let’s say that one point on the S&P 500 is worth one dollar.

That means the total cost of the position would be $7,912.14, and your initial margin requirement would be $79.12. In this situation, we will suppose you are wrong, and the GDP print disappoints.

This results in the S&P 500 falling, and you are stopped out of your trade at 2634.50.

You will have lost 3 dollars for every point that the index falls before you sell your position, so the loss of 2.88 index points will translate to an actual loss of $864, which is far more significant than your margin. This is an example of how quickly your margin can evaporate, and why keeping a tight stop loss is so important when trading with leverage.

Depending on your CFD broker, you may have to pay a fee when you open a position or a percentage of the gross value of the position. Every broker will have different requirements and costs, so it is imperative to understand their margin requirements and fee structure before you begin trading.

Short-Selling CFDs

Gaining short exposure to shares and equity indices with CFD’s is probably one of their best uses.

Because they don’t rely on access to the underlying instruments, CFD’s let investors short just about any financial market or product, without having to borrow shares, or find ways to structure a trade that shorts an entire market effectively.

Like any short, using CFD’s does open the investor up to unlimited losses if the trade goes the wrong way, but unlike shorting a stock, there will never be a shortage of shares, and thus, it will always be possible to cover the position.

Hedging with CFDs

For investors that want to lock in a high price for their stocks, or hedge a winning position, CFD’s make a lot of sense.

If you bought a position in a stock that has gone up, and you don’t want to sell it and incur capital gains taxes, buying a short position in CFD’s will cover your downside risk. It also is a very cost-effective way to do so, because you can buy a lot of exposure for a relatively small amount of money up front.

Hedging makes CFD’s a nearly ideal way to ensure a winning position, without having to worry about actually exiting the trade.