A CFD is a special instrument, known as Certificate for Difference, which allows traders to bet on the price and risk of an asset, without needing to acquire the underlying asset.
What is a CFD?
A CFD belongs to the class of so-called derivative products, meaning they derive their value from another tradable asset.
A CFD is a contract that may be bought or sold, carrying with itself specific rights to make a bet on the price movement of an asset.
A trader may want to trade in the price movement of securities (stocks), or every other derivative products.
A CFD may be based on any tradable asset that moves in price and has an opening and closing price.
As the name suggests, this type of trading instrument is only concerned with the difference in prices, and this is what is stipulated between the broker and the client.
No actual purchases of stocks are happening in this form of investment. This is crucial in avoiding a high margin requirement (50% usually), as well as a commission on the purchase and sale of the asset.
What the trader needs to be aware are the ask and bid prices for the CFD of choice.
To buy, a trader must pay the ask price; to sell the position, the trader needs to cover the bid price.
Additionally, brokers allow for different types of orders, such as stop or limit orders, as well as various forms of contingent orders, to mitigate the risk of this instrument.
There is no need to use a trading platform or register a stock sale, or use a forex or another type of market – CFDs are traded directly, over-the-counter through a broker.
How is a CFD Created?
A CFD is created when there is a need for a cash settlement in case of a difference between the closing and opening price of an asset.
This document allows the two sides in a deal to settle their balance without the need for delivering, or changing ownership of any type of asset.
Any market can generate a CFD – trading stocks, commodities, even futures and other types of derivatives.
What Does a CFD Do?
A CFD allows a trader to realize the gains in case an asset or a security price goes up.
The trader will realize a profit by receiving the difference between the CFD settlement price and the price of the underlying asset.
A CFD is also the possibility to enter any market – commodities, forex, stocks, even other derivatives, with no regard for geography, or needing to acquire the underlying asset.
Who Can Trade CFDs?
A CFD is a trade type readily available to investors in the European Union.
Regulations on transparency and borderless finance within the Eurozone allow European brokers to offer and execute CFD trades.
Unfortunately, CFDs are not permitted in the USA.
The reason for this is that a CFD is usually traded over-the-counter, or OTC.
This is a much less transparent market, and more difficult to regulate.
The ban on CFDs stems from the Securities and Exchange Commission, which has limited OTC trading in general.
CFDs are also considered risky. After the 2008 financial crisis that started with the collapse of Lehman Brothers, the SEC is much more skeptical about risky investment products and derivatives. No wonder, especially given that the crisis from a decade ago was triggered by derivatives.
The positive thing is, CFDs are available in many other jurisdictions and are well-regulated and legal.
How Risky are CFDs?
CFDs offer many advantages, but also multiple types of risk. Since those instruments are OTC-traded, one of the risks are the counterparties, which may not fulfill their financial obligations.
We can’t stress enough how important it is to trade only via regulated brokers like Plus550, Etoro or IG.
Of course, like any price tracking, there is the underlying market risk, or the fluctuation of the underlying asset price.
A CFD may amplify the effect of a rising or a falling price – and it can also offset risk. But there is no certainty on how the trade would work out.
Market risk is a vast topic, and may be affected by multiple factors.
Stock prices are sensitive to earning reports, general sentiment.
There are also government regulations, as well as macroeconomic factors that can sway asset prices in either direction.
Another type of risk is the fluctuation of the CFD price as well.
The contract may fluctuate and behave differently based on underlying liquidity.
However, a CFD in the end is always liquidated, as the broker has registered the contract and acts as a market maker.
Perhaps the most immediate risk is the triggering of a margin call.
For example, a trader can choose to leverage their position in a 2:1 ratio, meaning he has to put down $50 to take assets with a price of $100.
But if the price of the underlying asset falls by 25%, this triggers a margin call, meaning the trader will lose the initial $50 as their position is liquidated.
CFDs are offered by a special class of brokers, and in jurisdictions where CFDs trading are legal, there are counterparty rules to separate client funds from the seller’s own accounts.
Still, some pooling of client funds is happening, and in cases of unfavorable price action, the broker may use a part of the pooled fund to cover the losses.
CFDs in their very structure are capable of amplifying losses, as well as gains.
A market for CFDs may quickly lose liquidity and lead to the need to absorb losses.
So, Is CFD Trading Like Gambling?
What is gambling? It is betting on a predetermined outcome.
Sometimes, the outcome is binary, or it is one scenario out of a small pool of positive outcomes.
Whatever the game, whether heads or tails, roulette, or blackjack, the odds of an outcome are known and mathematically predictable.
Gambling has a big downside and a rare upside – the casino wins more often than not.
But the odds are known in advance, there are no unpredictable events.
You cannot throw a seven on a six-sided dice.
Even betting on a sports game has a clear and predictable outcome – either one team wins, or not.
More exotic forms of outcome prediction, such as political betting, elections outcomes, or other events with a dual outcome, are also relatively predictable, with a clear result in the end.
So it is easy to make the jump and decide that since CFDs make the bet on a stock price moving or not, they are like a simple betting game.
Either the price goes up, or it doesn’t. But this superficial comparison is misleading.
There are multiple factors in the movement of an asset’s price.
The outcomes are largely unknown, and several risk factors we already mentioned work together.
Certainly, a CFD can be high-risk or have a relatively good risk profile.
But there is no mathematical formula by which to calculate the exact odds for a given event, unlike the statistics in gambling.
Certainly, trading CFDs could be approached as a form of gaming, simply waiting for one of the outcomes.
But there is a crucial difference, and that is a dose of case-by-case research.
Research and information could present vastly different odds, and even show the potential for some rare and mostly unexpected events.
Not all unexpected events can be predicted accurately, but some may be mitigated.
Thus, instead of a game of chance, CFD trading should be a game of knowledge.
There is also the potential to decide on a sum that is worth risking.
CFD losses can suddenly deepen from a single bet, losing at the least the market price.
Here’s a CFD Example!
Suppose a stock has been picked, with the potential to move favorably.
At the initial moment, it is possible to buy 1,000 CFDs on this stock, offered by a broker.
The selected stock trades at $1.5 at the moment of purchase, so the contract starts at this price.
But the trader will not need to buy the entire contract, only putting in a margin deposit for a fraction of the sum.
If the stock rises to $1.70, the trader will be able to sell the CFDs, provided there is enough liquidity, and lock in $200 in gains.
However, if the stock price falls, the trader may need to cover the position price, incurring losses.
It is also possible that the CFDs lose liquidity and there are not enough buyers, once again leading to losses.
Thus, a CFD works in both directions – bringing relatively large and fast gains if the trader has guessed the right type of price movement, or obliging the trader to pay the difference if the price moves unfavorably.
How CFD Trading is Different from Gambling
CFD trading is relatively complex.
As the example above shows, a trader should better know the possibilities for a stock price movement, before buying a CFD.
The biggest risk is the market fluctuation of the underlying asset – and this is what the trader needs to guess.
But even guessing the outcome is not entirely like gambling.
CFDs in fact allow a trader to tailor their risk and bet both ways on an asset price movement.
CFDs allow a trader to take a position that is either long or short, that is, expecting that the stock or another type of asset would go higher or lower.
For an even more fine-tuned approach, a trader can tailor the risk for a given price percentage move, and to potentially limit the losses.
On the contrary, in gambling, the risk is straightforward, unchangeable, and known statistically in advance.
Some types of CFDs have a predetermined price per point risk, as for instance trading on an index difference.
The contract stipulates how much is earned or lost for each point the underlying index moves.
CFD Trading is Fast
CFD trading is not a buy-and-forget type of investment strategy.
The trader must be aware of margin requirements, ask and bid prices, and the general market movement.
Once the underlying asset moves in a way that triggers margin requirements, the trader must cover those, and potentially suffer losses, despite a subsequent recovery of the asset.
In that way, CFD trading is much like gambling, in that the result of your intentions is known soon, and the gain or loss completed within the framework of day-trading.
Additionally, sudden and sharp price movements of the underlying asset mean a loss can be incurred even when there are special orders in place.
Additionally, trade lags and information speed may mean the exact risk is difficult to estimate, and the trader may be exposed to a loss unexpectedly.
The above list of personal risks is one of the reasons why US-based traders are not allowed to trade in CFDs, as regulators attempt to protect them from unexpected losses.
Choose the Right Broker
While CFD trading is highly regulated, the success of a trade depends on the reputation, skill and the specific requirements on margins, fees, and the spreads allowed.
A trader may offer slightly unfavorable spreads, and in the end lead to losses on a CFD position.
In this manner, CFD trading is not unlike gambling – there are more or less reputable spots, as well as different games that can be played.
So, Are CFDs Worth the Risk?
CFDs allow any trader to gain access to non-stop, international trading, based on any asset of choice.
The only thing that matters is that CFD brokers are allowed to act in the trader’s region of residence.
CFDs allow traders to bypass traditional markets and stockbrokers, and place bets on price movements without resorting to stock or forex exchanges or brokers.
CFDs are much more accessible, promising relatively high returns and low or zero fees or commissions.
All gains made on trading CFDs are net gains, commission-free.
While margin calls exist, they are relatively lower and depend on the volatility of the underlying product, and the risk per unit of price movement.
CFDs are among the most popular derivative instruments, and are available in countries with relatively stringent financial regulations, including Canada, France, Germany, Japan, the Netherlands, Singapore, South Africa, Switzerland and the United Kingdom.
Approaching CFD trading like gambling is risky.
Education and using a demo account first may mitigate some of the risks, and show how fast a loss can be incurred.
CFDs allow for a relatively small investment, but it is still best to make sure the loss from a margin call can be afforded.