Online CFD trading industry has seen considerable growth over the past two decades. CFDs are often considered as an alternative to regular markets, as they provide a range of distinct advantages for investors. However, the use of leverage will bolster both potential profits and losses, which requires a careful approach to CFD markets and a sound risk management. Yet, we should note that despite all risks associated with CFDs, which we will pay attention to in the present guide, it is possible for one to generate gains when trading these complex instruments.
In the current guide, we will discuss what CFDs represent and how they work as well as their costs, pros and cons. We will also dig deeper into the concepts of margin and leverage trading. Finally, we will offer a simple CFD trading strategy based on technical studies.
What is a Contract for Difference (CFD) and how does it work?
A Contract for Difference, or CFD, represents a sort of agreement between a CFD brokerage and a CFD trader (client) to exchange the difference in value of a particular trading instrument (Commodity, Stock, Stock Index, Cryptocurrency etc.) between the moment the contract opens and closes. A CFD contract’s value is not related with the value of the underlying asset – what’s essential here is only the price change between a position’s entry and exit points.
With CFDs, traders are enabled to profit from price movement without the need to actually own the underlying asset. There will also be no delivery of actual (physical) securities or goods. Instead of purchasing and selling physical barrels of crude oil, for example, you can simply speculate on the direction of its price.
CFDs include two trades – the first trade establishes an open position, which you later close out via a reverse trade with the CFD broker at a different price. In case the first trade is a long position (buy), the second trade (the closing-out trade) will be a short position (sell). And if the first trade is a short position, the closing-out trade will be a long position. Your net result (profit/loss) will be the price difference between the first trade and the closing trade.
CFDs can essentially be used to make predictions about whether or not the price of a given trading instrument will move up or down. If you are convinced that the price of the underlying asset will rise, you may place a CFD buy position. In case the market indeed moves as you expected, you may want to sell your holding. The net difference between the price of purchase and the price of sale will be netted together. The net difference – the profit from both trades, will be settled through your trading account with the CFD brokerage. Conversely, if you are convinced that the price of the underlying asset will fall, you may place a CFD sell position.
What are the costs of CFD trading?
When you trade CFDs, you will incur the following costs:
|Type of cost||Explanation|
|Spread||The cost incorporated into the price of the instrument you trade. It is the difference between the bid price and the ask price. Brokerages have begun to offer tighter spreads on CFDs due to intense competition in the industry.|
|Commission||A flat fee paid per position often used as an alternative to charging via the spread. When trading Forex pairs on a Standard Account, you will not be charged any commissions. However, ECN Accounts will charge a small commission per Standard Lot (100,000 units) traded. There will also be no commissions charged on Commodity CFDs, Stock Index CFDs and Crypto CFDs. When trading Stock CFDs, you will be charged commissions for both opening and closing of positions. Those charges will vary depending on the exchange where the Shares are listed.|
|Overnight Financing Charge||The cost of holding a position active overnight. There will be a charge on each of the days you hold the position. The charge will depend on the trading instrument and the direction of the trade (long or short).|
Let us visualize those with the following example. You decide to buy CFDs on Barclays PLC stock, whose current price is GBP 185 per share. You expect that the share price will rise to GBP 210 per share. When you open the position you will be charged a 0.1% commission and there will be another 0.1% commission on closing the trade. You place a long trade and will incur an overnight financing charge – usually it is based on the LIBOR interest rate plus a markup of 2.5%.
You decide to purchase 110 CFD contracts at GBP 185 per share, thus, your position size is GBP 20,350. Let us assume that the share price of Barclays rises to GBP 210 in 15 days. The initial value of your trade is GBP 20,350, while the final value is GBP 23,100. This way, your profit, prior to charges and commission, will be GBP 23,100 – GBP 20,350 = GBP 2,750.
Since the commission is 0.1%, when you open the position you will pay GBP 20.35. Let us assume the overnight financing charge is 7.5%, which you must pay on each of the 15 days you hold the position. (110 x GBP 185 x 0.075/365 = GBP 4.18). As you keep the position active for 15 days, the total charge will be 15 x GBP 4.18 = GBP 62.70.
When you close the position, you will have to pay another 0.1% commission, or GBP 20.35.
Finally, your net profit will equal total profit minus charges, or:
GBP 2,750 (profit) – GBP 20.35 (commission) – GBP 62.70 (financing charge) – GBP 20.35 (commission) = GBP 2,646.60.
In which jurisdictions can you trade CFDs?
CFDs are allowed in listed, over-the-counter markets in a number of major economies such as Germany, the United Kingdom, France, Switzerland, Canada, Singapore, Spain, Italy, Hong Kong, Australia, New Zealand, Thailand, Sweden, Norway, Denmark and the Netherlands. However, in key jurisdictions such as the EU, the UK and Australia certain leverage restrictions have been imposed on CFD products offered to retail clientele (check out the “leverage” section of our guide for more info).
On the other hand, CFD trading is prohibited in the United States. The reason for that is in part related to the fact CFDs are over-the-counter instruments, or they do not pass through regulated exchanges. In addition, the use of leverage makes it possible for larger capital losses to occur, which is a concern for regulatory authorities.
CFDs are also prohibited in Belgium, Hong Kong and Brazil. Yet, residents of Hong Kong and Brazil are able to trade CFDs with overseas brokerages.
What are the benefits of CFD trading?
First of all, CFDs provide the opportunity to use higher leverage ratios compared to traditional trading. CFD leverage varies depending on the regulation jurisdiction. At one time, traders were able to use leverage of 1:100 and higher, but currently, there have been strict leverage restrictions imposed by regulators in some jurisdictions, with the objective being to protect retail investors. Higher leverage translates into less capital outlay for the investor and higher potential returns. Yet, it also amplifies potential losses. (Check out the margin and leverage sections of the current guide for more info).
Second, traders are able to access global financial markets through a single platform. Nowadays CFD brokerages offer trading instruments across all of the major markets globally and allow simple, 24-hour access via their trading platform.
Third, with CFD brokerages, traders will be able to use most of the same order types, which traditional brokers offer. Those include Stop orders, Trailing Stop orders, Limit orders along with some contingent orders such as “One cancels the other”, all available free-of-charge. Some CFD brokers will also offer Guaranteed Stop orders, but the latter will usually involve a small fee or an extra spread. In most cases, CFD traders will pay the bid-ask spread only and, on some occasions, a commission (as we discussed earlier). How narrow or wide the spread is depends on the particular instrument’s volatility. Some CFD brokerages will also offer fixed spreads (for example, on major and on some minor currency pairs).
Fourth, there are no shorting rules in CFD trading. In some markets, there are rules which do not allow shorting, or require investors to borrow the particular asset first before selling it short, or require different margins for long and short trades. In comparison, traders are able to short derivative instruments such as CFDs at any time with no borrowing costs involved.
Fifth, with CFDs, there are also no day trading requirements. To day trade some particular markets investors are usually required to ensure a minimum capital amount. In other markets, there are limitations on the number of day trades investors can place within a particular account type. No such restrictions exist in the CFD market and day trading is allowed for all account holders. CFD brokers require reasonable minimum deposits to open a live trading account, usually $100 to $500 for an account with standard properties.
And finally, there is a variety of markets to trade. At present, CFD brokers allow access to tradable asset classes such as Foreign Exchange, Cryptocurrencies, Commodities, Stock Indices, Stocks, ETFs, Treasuries, Options, Interest Rates, Sectors among others. This way, speculators have a wide range of options to trade CFDs as an alternative to strictly regulated markets (exchanges).
What are the drawbacks of CFD trading?
First, when trading CFDs you need to pay the bid-ask spread on position entries and exits. This way, your potential to generate gains from small price moves is greatly diminished. Spread costs also reduce earnings from successful trades by a small amount and increase losses by a small amount.
Second, CFD trading involves a variety of risks, which you should be aware of before placing your first trade.
|Type of risk||Explanation|
|Counterparty risk||When you purchase or sell a CFD, the only asset that is being traded is the contract the CFD broker issues. Thus, you will be exposed to the CFD broker’s other counterparties (including clients the broker does business with). There is a risk that the counterparty does not manage to meet its financial obligations. In case the CFD provider defaults on its contractual obligation, then the value of the CFD contract becomes irrelevant. You should always do a profound research of the brokerage you intend to open an account with.|
|Market risk||In reality, nobody can be 100% correct in their predictions of market movement. Sometimes, unexpected changes in market conditions, or macro data, or government policy can lead to quick changes in prices. Because of the sheer nature of derivatives such as CFDs, small changes may have a huge effect on traders’ returns. If there is an unfavorable effect on the price of the underlying asset, the CFD broker may require an additional margin payment. If you fail to meet a margin call, the CFD broker may close your position, or you may need to sell at a loss.|
|Client money risk||In every jurisdiction where CFD trading is allowed, there exists client money protection legislation aimed to safeguard investors against possible fraudulent behavior of CFD brokers. All client money transferred to a CFD brokerage is required to be kept fully segregated from that company’s own funds. This way, the CFD broker will not be able to hedge its own investments. Still, the legislation may not necessarily ban client money pooling into one or more accounts. At the moment a CFD contract is agreed upon, the broker will withdraw an initial margin from the pooled account and it also has the right to request more margins from it. Note that in case some of the other clients in the pool do not manage to meet margin calls, the CFD broker has the right to withdraw from the pooled account. This could potentially affect traders’ returns. (We discuss margins and margin calls in detail in the following section of the guide.)|
|Liquidity risk||Market conditions affect a huge number of financial transactions. At times, there could be not enough trades in the market for a particular instrument and, as a result, your existing CFD contract could turn out to be illiquid. In such a case, your CFD broker may require extra margin payments, or close the contract at unfavorable prices.|
|Leverage risk||Potential losses are amplified along with profits. Traditional Stop-Loss orders available with the majority of CFD brokerages will not guarantee you won’t incur losses – especially in the event of market closure, or during sudden price moves. Some brokers offer additional risk management tools such as Guaranteed Stop Loss orders, but at an extra cost.|
|Execution risk||You should be aware that negative slippage may occur at any time (your position may close at a worse price level than anticipated due to latency or other factors). Reputable CFD brokers will usually disclose their execution statistics.|
Third, regulation of the CFD industry is still not that rigorous. How credible a particular CFD brokerage is depends on its reputation, business history and financial position, not on government standing or liquidity. Before making a decision to open a live trading account, you should do an in-depth research of the particular CFD broker.
Let us consider the following example. The shares of Boeing Co have an ask price of $180.75 and you intend to purchase 50 shares. The total cost of the transaction (plus commissions and fees) is $9,037.50. A traditional broker will usually require a 50% margin, or at least $4,518.75 in free cash. Meanwhile, a CFD broker will require only a 5% margin, or $451.88. Note that a loss on a CFD position equals the size of the spread at the moment of the transaction. In case the spread is $0.10, the stock will have to gain $0.10 so that the position can reach the break-even price. If you owned the stock outright, you would see a $0.10 gain and would also pay a commission, which would result in a bigger capital outlay.
In case the stock surges to a bid price of $182.00 and you are using a traditional brokerage account, your profit when selling the stock will be $62.50, or 1.38% ($62.50 / $4,518.75 * 100%). Still, when the stock exchange reaches the bid price of $182.00, the CFD bid price may be $181.75. The profit from the CFD trade will be lower, since you are required to exit at the bid price, while the spread is wider compared to the traditional market. Here, as a CFD trader, you will earn a profit of $50, or 11.06% ($50 / $451.88 * 100%). Note that the CFD brokerage may require of you to buy at a higher ask price, $181.00 for instance. Still, the $50 profit from the CFD trade represents a net profit, while the $62.50 profit from owning the stock outright does not account for commissions or other fees. Therefore, as a CFD trader, you will generate a larger net result.
Now let us discuss the concepts of margin and leverage in more detail.
What does the term “margin” mean?
Trading CFDs on margin allows you to employ leverage when you operate with various financial instruments (Stock Indices, Foreign Exchange, Cryptocurrencies, Commodities, Stocks, ETFs and so on). This way of trading enables you to open larger-sized positions in the market, while you deposit only a small initial amount.
When you trade CFDs on margin, you will be required to deposit only a certain percentage of the entire value of the trade in order to enter the market. This deposit is usually referred to as a “margin requirement”.
Online brokers usually require different margin rates for particular financial instruments. But generally, the more volatile the price of a certain instrument is, the higher the broker’s margin requirement will be.
The margin rate allows you to know what amount of capital you need in your trading account in order to make a CFD trade. In case you are trading a currency pair with 3.34% margin rate, this means you only must have 3.34% of the full trade value in your account to place the trade.
Margin trading actually allows you to invest larger amounts than the funds you have deposited in your trading account with a particular online brokerage. To do so, you actually borrow money from the broker in order to leverage your active positions in the market and to bolster your profitability potential. We should note that when you trade CFDs on margin, your profits and losses will be based on the entire value of your trading position.
Margin trading with the use of leverage will amplify your gains, but it will also amplify your losses (in case the market moves against you). In this line of thought, margin trading can be considered as a double-edged sword, because high leverage coupled with high volatility may lead to rapid losses, which can even exceed your initial deposit (you may end up owing the broker money). The latter is especially valid, if the brokerage does not offer its clients risk management tools such as negative balance protection. Brokers offering negative balance protection will usually absorb losses that exceed the initial deposit and restore your trading account balance back to zero.
What does the term “leverage” mean?
When we speak about leverage in CFD trading, we mean the ratio associated with the margin amount, which determines the size of a given trade. If we have a leverage ratio of 1:20, this means the required margin to open and maintain a trading position is one twentieth of the total transaction size. This means we need to ensure $1,000 in order to place a trade for $20,000. So, the margin amount will be the percentage of the total value of the trade, which we need to ensure to place the trade. If we are willing to make a $20,000 trade on a given financial instrument that has a leverage ratio of 1:20, our broker’s margin requirement will be $1,000.
As we said earlier, margin trading with leverage can magnify both profits and losses. Practice has shown that many retail traders see their margin wiped out in a very short period of time, just because they use way too high leverage ratios. If you are a beginner, it is highly recommended that you trade CFDs with a lower leverage ratio than the maximum leverage allowed for the particular instrument. A lower leverage ratio means that it is less likely to wipe out all of your trading account balance if you have a series of incorrect projections of price movement for a given market.
The leverage ratio can be calculated with the use of a simple formula:
L = A / E,
where L refers to leverage, A refers to asset amount and E refers to margin amount or equity.
It is also possible to determine the size of a trading position with the use of the margin amount and the leverage ratio. In this case, the formula will look like the following:
A = E x L.
Another important moment to note is that leverage ratios will be different, depending on the experience and skill level of traders – either retail traders or professionals. Strictly regulated online brokerages will offer considerably lower leverage ratios for retail clients – for example, 1:30 on Forex pairs. Brokers are required to do so under the respective regulatory guidelines as well as the jurisdiction where they operate. Professional traders, on the other hand, will have access to much higher leverage ratios across all asset classes available with the particular brokerage – 1:100, 1:500 (in Australia and New Zealand, for example) and even 1:1000 (in South Africa). To be eligible for the qualification “professional trader”, however, clients must satisfy strict criteria, including relevant experience in the financial field, assets under management of a certain minimum amount, a particular number of executed trades of considerable amount and so on.
In an attempt to improve customer protection, regulatory authorities have imposed strict leverage caps for CFD trading. In the European Union and the United Kingdom, for instance, under ESMA/FCA rules, the highest leverage ratios offered to retail traders are as follows:
- Major Forex pairs – up to 1:30;
- Minor and exotic Forex pairs, Gold and major Stock Indices – up to 1:20;
- Commodities (excluding Gold) and minor Stock Indices – up to 1:10;
- CFDs on Government Bonds – up to 1:10;
- CFDs on Stocks – up to 1:5;
- CFDs on Cryptocurrencies – up to 1:2. Note that, in January 2021, the FCA prohibited selling Crypto CFDs to retail clients residing in the UK.
When it comes to jurisdictions such as the United States, CFD trading there has been prohibited since the passing of the Dodd-Frank Act in 2011. Still, US-based retail clients are allowed to trade Forex pairs with maximum leverage of 1:50, under CFTC rules.
Now let us consider an example of leverage use in Stock CFD trading. An EU-based trader decides to open a position in Microsoft shares by using leverage of 1:5, while his/her account balance is EUR 100,000. The trader’s position size now becomes valued at EUR 500,000, which has given him/her exposure to 5 times as many shares compared to if he/she had bought the instruments outright without the use of leverage. However, note that to maintain a leveraged position in Microsoft stock, the trader’s account balance must remain above the maintenance margin requirement of 50%. In this case, it is EUR 50,000.
Initial margin and maintenance margin
The initial margin represents the minimum amount of capital you need to ensure to place a trade in a certain CFD product. Depending on profits or losses on the trade, your account balance will fluctuate. If your trading position falls to 80% of the initial margin level, this will lead to an occurrence known as a “margin call”. As a result, you will be asked to deposit additional funds into your account before the maintenance margin level is reached. And if your account drops below the maintenance margin level, you will be closed out of your position. At most brokerages, the maintenance margin level is set at 50% of the initial margin.
We can say that the maintenance margin represents the lowest amount of capital your trading account must have to maintain a leveraged position open. The maintenance margin requirement is meant to protect both traders and brokerages from excess losses. When you place a trade, you actually reach an agreement with a party on the opposite side of the transaction. Both parties must ensure they can hold up their end of the deal and have sufficient amount of capital to cover any losses, if such occur.
The maintenance margin represents a close-out level, which indicates your account balance is too low to keep your position or positions active. You will need to add more funds to your trading account prior to reaching the maintenance margin level, or simply to close some of your active positions. If the maintenance margin level is reached, your position will be automatically closed.
Let us have the following example. You decide to place a long trade in the EUR/JPY currency pair, because you expect the Euro will appreciate in value against the Japanese Yen. You place a trade with a total position value of EUR 10,000, which is how much currency you purchased at a price of ¥131.00. You are not required to have the amount of EUR 10,000 in your account to place the trade. Instead, you need to ensure only 3.34%, or EUR 334, of that amount, as required by your broker. This is the initial margin needed to place the trade. As long as you have at least EUR 334 in your account, an amount which is not being used as margin for other positions, you will be able to place the EUR 10,000 EUR/JPY trade.
The margin call level is set at 80% of the initial margin. In case the balance of available funds drops below EUR 267.20 (80% x EUR 334), then you will be required to deposit more funds in order to restore the available account balance to a minimum of EUR 334.
Let us assume that you have EUR 400 in your account at the time when you place the trade, but you are currently losing EUR 140. As a result, your account balance has now decreased to EUR 260, which is actually below the 80% margin call level (EUR 267.20). You will be alerted that you must bring the account balance back up to the minimum of EUR 334, but the trade will remain active, because the maintenance margin level is at EUR 167 (50% x EUR 334). Let us assume that EUR/JPY continues to depreciate and you are now losing EUR 240. As a result, your account balance has now dropped to EUR 160, which is below the maintenance margin level (EUR 167). In this case, you will be automatically closed out of the position.
In order to avoid receiving a margin call notification and, after that, reaching the maintenance margin, you may take into consideration the following:
- First, maintain your leverage exposure at a reasonable level by closely watching your position size. If you place a large-sized position relative to your account balance, then a small price change may lead to a large percentage change in the value of your account;
- And second, make sure you always have more funds in your trading account than the broker’s margin requirement. If there is a margin requirement of $200, for example, for a particular trade, having at least triple (or even more) of that in your account may diminish the probability of receiving a margin call notification.
Buying on margin versus buying with cash
The most notable differences between buying on margin and buying with the use of a cash account can be presented as follows:
|Buying on margin||Buying in a cash account|
|You need to ensure only a part of the transaction value in your account when you place the trade||You need to ensure the entire transaction value in your account when you place the trade|
|You can amplify your profits as well as your losses. They will equal the price movement of the particular asset class multiplied by leverage||Your profits and losses will not be amplified. They will be based on price movement of the particular asset class|
|Margin rates required will be different depending on the asset class||Margin rates will be of no importance since you are funding the entire transaction|
|The amount of money you leverage is associated with borrowing costs or overnight holding costs||You will incur no borrowing costs|
|You can place long and short trades in a margin account||To place short trades you will need a margin account|
Margined products such as CFDs and spread betting are associated with borrowing costs. This means if you keep a leveraged position active overnight, you will incur overnight holding costs. At the end of every day, at 5:00 pm New York time, all CFD positions that you hold in your trading account will be subject to a charge – “holding cost”. Overnight fees usually depend on the asset class and the direction of the trade (long or short position) and can be positive (you will receive interest when holding the position overnight) or negative (you will incur a charge).
Overnight holding costs are usually based on the respective interbank rate plus a small mark-up. Interbank rates are different depending on the country, thus, overnight holding costs will be different depending on the asset’s home currency. In the case with US Stocks, for example, overnight fees will be based on the US interbank rate.
Now let us consider the following example so that you can better understand the difference between buying on margin and buying with cash. You are willing to buy 100 shares of Ford Motor Company stock, trading at $27. The total value of the transaction is $2,700. However, a margin trader will be required to ensure only 20% of that value in his/her trading account, or $540. Let us assume the price of Ford shares surges to $32 and you decide to sell. You will generate a profit of $3,200 – $2,700 = $500. This is a $500 profit on $540, since the latter was the margin required to place the trade – this translates into a profit of $500/$540*100% = 92.6%. If you had accessed a cash account with $540 in it, then you would have been able to buy only 20 shares, not 100. With a cash account, your profit would have been 20 shares x $5 profit = $100, or 18.5%.
CFD trading versus Stock trading
|CFD trading||Stock trading|
|Long and short positions||Traders can profit from both long and short positions||Traders can profit only when the price rises (only from long trades)|
|Trading hours||24 hours a day, 5 days a week||Only during a stock exchange’s business hours|
|Costs||Spreads, Commissions, Overnight financing charges||Commissions only|
|Do traders own the underlying asset?||No||Yes|
|Dividends||A cash adjustment will be applied for dividends||Yes, only if the particular company decides to pay such|
|Leverage||Leveraged positions are allowed, but margin requirements vary depending on brokers’ regulation jurisdiction and on the asset class. Max retail leverage in the UK and in the EU is capped at 1:30 (which translates into a 3.3% margin requirement)||Traders cannot place leveraged positions|
|Range of markets||A variety of trading instruments across asset classes such as Forex, Commodities, Stocks, Stock Indices, Crypto, Futures, Options, ETFs, Bonds etc.||Stocks and ETFs only.|
A simple CFD trading strategy based on Slow Stochastic and Relative Strength Index indicators
And finally, we offer a simple to understand and to employ trading strategy based on technical studies entirely. Let us take a look at the 1-hour chart of AUD/USD and deploy:
The Slow Stochastic Oscillator set as follows:
- time periods of 5, 3, 3
- oversold level of 25.00
- overbought level at 75.00;
The Relative Strength Index set as follows:
- time period of 7
- oversold level of 25.00
- overbought level of 75.00.
We will also be paying attention to certain candlestick setups.
In order to place a long trade, you will need to look for the following conditions:
- The Slow Stochastic Oscillator and the Relative Strength Index are both below their midpoint level and near their oversold levels;
- There is a bullish candle (green), whose closing level is at the midpoint of the previous bearish candle (red).
In order to place a short trade, you will need to look for the following conditions:
- The Slow Stochastic Oscillator and the Relative Strength Index are both above their midpoint level and near their overbought levels;
- There is a bearish candle, whose closing level is at the midpoint of the previous bullish candle.
In order to exit your short trade, you will need to look for the following:
- The Slow Stochastic Oscillator and the Relative Strength Index are both in their oversold areas;
- There is a bullish candle, whose closing level is at the midpoint of the previous bearish candle.
You may look for the opposite scenario to exit your long trade.
CFDs represent a good alternative to traditional markets and one is able to generate profits trading these complex instruments despite the high risk they are associated with. You should remember that along with their advantages (lower margin requirements; easier access to financial markets; low or no fees; no shorting rules and no day trading rules), CFDs also have particular disadvantages (high leverage ratios amplify not only potential profits, but also losses; paying a bid-ask spread when entering and exiting trades may be costly in case more pronounced price movement does not occur).
Therefore, to manage your risk exposure you should pay attention to your leverage ratio, make sure you have enough funds in your account to meet the CFD broker’s margin requirement and also make sure you are not risking more than 1%-2% of your total account balance on a single trade. Last but not least, make sure you always employ all the risk management tools available with your brokerage – Stop Loss orders, Trailing Stops, Guaranteed Stops and etc.