With a CFD, or contract for difference, you can speculate on the rising and falling prices of securities such as stocks, commodities, index funds, and cryptocurrencies! But what are CFDs exactly? In this explanation, you will learn everything you need to know about CFDs!
What is a CFD?
A CFD is a derivative and relates to another investment product. For example, you can buy an Apple CFD. The result you achieve with a CFD investment depends on the difference between the moment you open the position and the moment you close it. This means you don’t invest in the stock directly; instead, you invest in the price difference between the opening and closing moments.
How does a CFD work?
You can buy a CFD from a broker, who then pays out any profits or deducts losses.
Long and short
You can speculate on both a rising and falling price with CFDs:
Long: With a long position, you speculate on a rising price.
Short: With a short position, you speculate on a falling price.
The difference between when you open and close a CFD position determines your result. If you invest in a stock for $10 and close the position at $8, you would achieve the following results:
Long: A loss of $2 per share
Short: A profit of $2 per share
Leverage
CFDs often use leverage. With leverage, you can take a larger position with a smaller amount of money. You can achieve a higher profit with leverage with the same amount of money, but the risk is also higher.
Margin
To keep your CFD position open, you need a margin. If you no longer have enough money in your account, your position can be closed automatically. When investing in CFDs, you will encounter two types of margins:
Initial margin: This is the amount you need to open the position. With a leverage of 1:20, you need at least 5% of the total amount in your investment account.
Maintenance margin: This is the amount you need to keep your position open. If there is no longer enough money in your account, you can deposit more. If you do not do this, your position will be closed automatically. This is also known as a margin call.
No fixed expiration date
Unlike, for example, futures, CFDs have no fixed expiration date. You ultimately decide how long you want to keep the CFD position open.
Where can you invest in CFDs?
You can invest in CFDs with a CFD broker. With most brokers, you can try trading CFDs without any risk by using a demo account. This is definitely recommended: it allows you to discover whether this investment product is suitable for you. Use the button below to compare the best demos directly:
Leverage: You can take a larger position with a small amount of money.
Speculate in both directions: You can speculate on rising and falling prices.
Transparent: The CFD moves along with the price of the underlying asset.
Relative costs: You do not pay fixed commissions with most brokers.
Limit losses: You can limit your losses with a stop-loss order.
No expiry date: CFDs do not have a fixed expiry date.
Hedge: You can protect your portfolio with CFDs.
Free trial: You can try CFD trading with a demo account.
Many markets: You can trade in commodities, among others.
In this article, you can read in more detail about the advantages of investing in CFDs.
What are the disadvantages of a CFD?
Leverage risk: You can lose money much faster with CFDs.
Financing costs: CFDs are only suitable for the short term.
Requires time: You need to trade actively to achieve results with CFDs.
Higher transaction costs: The leverage also applies to transaction costs.
No real shares: You are not a co-owner of the company.
Reliability: Not every CFD broker is equally reliable.
Unclear pricing: The price is determined decentrally.
In this article, you can read in more detail about the disadvantages of investing in CFDs.
Costs of a CFD
When you invest in CFDs, you will encounter various costs:
Spread: The spread is the difference between the buying and selling price.
Financing costs: You pay daily interest on your investment.
Slippage: The price of a CFD can be higher than expected.
Conversion costs: You pay money for the exchange of currencies.
If you want to read more about how high the costs of investing in CFDs are, read this article!
Example of a CFD transaction
The pandemic breaks out and I decide to capitalize on it. Countries close their borders and global economies shrink due to lockdowns. I expect the demand for oil to decrease as a result, so I open a short position. With a short position, I achieve a positive result when the price falls.
I open the position at a price of $40 and close it at a price of $20. I do this with an amount of $1,000 and a leverage of 1:10. This means that I buy $10,000 worth of CFD oil barrels with $1,000.
The price drops by 50%. However, by using a leverage of 1:10, I achieve a profit of 500%! As a result, I close the position with a positive result of $5,000. Keep in mind that leverage works in two directions, so you can quickly lose your entire investment!
What can CFDs be used for?
Option 1: Short-term speculation
CFDs are very suitable to quickly respond to the latest market developments. You can use CFDs to react to both positive and negative market conditions.
Option 2: Hedging
You can protect your existing stock portfolio by using CFDs. Do you expect the entire market to decline? Then you can use CFDs to go short temporarily. Read more about hedging here.
Option 3: Trading in hard-to-reach markets
As a private investor, it can be difficult to invest in commodities. With CFDs, you can speculate on almost anything: think of pigs or aluminum, for example!
What are the risks of CFDs?
Market risk: the price of the underlying asset can move in the wrong direction, resulting in losses.
Leverage risk: losses can quickly accumulate with leverage.
Counterparty risk: if the counterparty (the broker) goes bankrupt, you can lose your position.
Gap risk: when the market closes, the price can be lower or higher on the next trading day.
Interest rate risk: you pay interest on investments in CFDs, and this interest can increase.
Currency risk: currencies fluctuate in value, which can result in losses.
Liquidation risk: if you do not have enough margin in your account, you may lose your investment.
What happens to dividends in CFDs?
Long position
You receive the dividend, but the price decreases by the value of the dividend. This means that the dividend payout does not directly affect your CFD position.
Short position
You pay the dividend, but this is offset by the decline in the market price. This means that the dividend payout also does not affect your short CFD position.
For which type of investor are CFDs suitable?
CFD’s are risky investment products. Due to the presence of leverage, you can quickly lose your entire investment. CFDs are therefore only suitable for experienced investors; do thorough research to determine if CFDs are right for you.
Conclusion: Are CFDs Attractive?
CFDs are not attractive for every investor. However, the enormous popularity indicates that many people are interested in this investment instrument.
Personally, I find CFDs interesting because you can quickly respond to the latest price developments. Additionally, because you can apply leverage, you can achieve a higher potential profit. Furthermore, the selection of CFDs is enormous: it has never been easier to speculate on the price of commodities, for example.
However, there are significant risks associated with CFDs, and they are not a way to get rich quickly. Do thorough research and practice extensively before investing in CFDs. Additionally, only invest money in CFDs that you can afford to lose.
Frequently Asked Questions About CFDs
CFDs are leverage products that allow you to speculate on short-term price movements. No actual product is delivered, which means you do not buy an actual share. The difference between the opening and closing prices determines your result. The broker is the counterparty in CFD trading.
A CFD tracks the price development of an underlying asset. You then speculate on the price development of a CFD.
With a long position, you first buy the asset and then sell it. The difference between the two values determines your result.
With a short position, you first sell the asset and then buy it. The difference between the two values determines your result.
Investing in CFDs is seen as very risky. Due to the presence of leverage, you can quickly lose a significant amount. Therefore, thoroughly study the risks of CFDs before investing!
Absolutely! There are plenty of successful investors who earn substantial amounts with CFDs. These are often the real go-getters who have years of experience. It takes time to become really good at active investing. Therefore, remember that trading CFDs is not a way to get rich quickly.
The biggest difference between CFDs and futures is that with futures, you are obligated to take delivery of the underlying asset at the end of the term. When you buy a future on oil, for example, you must actually buy the barrels at the end of the term. Moreover, you need significant amounts of money to invest in futures, while you can start with CFDs from $100. Therefore, I am a bigger fan of CFDs, as this investment product is more accessible.
CFDs were developed in the 1990s by Jon Wood and Brian Keelan. Initially, CFDs were only accessible to professional investors and companies, but this later changed. Nowadays, CFDs are an indispensable part of the investment landscape.
When you buy a stock, you are the direct owner of the asset. You have voting rights, and the price increases and decreases are directly reflected in your investment account.
With a CFD, you are not the owner of the asset. You only speculate on the price increases and decreases of the underlying asset.
Although CFDs and options have similarities, the investment products are different. With an option, you buy the right (but not the obligation) to buy the underlying asset. With a CFD, you only speculate on the price movements of the underlying asset without ever owning it. Click here to read everything about investing in options!
