A Contract for Difference (CFD) is a contract between two parties (the buyer and the seller) where one party commits to pay the difference between the current value of an asset and its value at contract time.
Before you enter into a Contract for Difference, it is important to read and understand the terms and conditions of that specific contract to avoid surprises.
Contracts for Difference used to be strongly associated with big institutional investors and hedge funds, but have in the 21st century also become immensely popular among retail investors. Today, many trading sites online offer CFD:s that can be purchased for a very small amount of money – and they also offer leverage.
The basic idea behind a CFD is fairly straightforward. You do not purchase the underlying asset. Instead, you enter into a contract whose value follows changes in the price of that asset. If you correctly predict the direction of the market, the difference between the opening and closing value can produce a profit. If the market moves in the opposite direction, the same mechanism produces a loss.
This makes CFDs derivatives. Their value is derived from something else, such as a share, currency pair, commodity, stock index or another financial instrument. The trader is therefore obtaining price exposure rather than ownership. Someone trading a CFD based on a company share does not normally become a shareholder in that company simply because the CFD rises and falls with the share price.
The simplicity of the basic contract can be deceptive because several other factors affect the final result. Leverage, margin requirements, spreads, commission, overnight financing, slippage and the rules used by the broker can all change how profitable or costly a CFD trade becomes. Two traders can make the same market prediction but receive very different results if they use different position sizes or hold their trades for different lengths of time.
How does a CFD work?
Suppose a share is trading at 100 USD and you believe its price will rise. Instead of buying the share, you open a long CFD position based on its price. If the share later rises to 105 USD, the CFD has moved 5 USD in your favour for each unit represented by the position. If the market falls to 95 USD, the same 5 USD movement works against you.
A short CFD works in the opposite direction. You open a sell position because you expect the underlying market to fall. If it does, the trade can become profitable. If the underlying market rises instead, the position loses value. This ability to move between long and short exposure without first owning the underlying asset is one of the reasons CFDs became popular among active traders.
The final profit or loss depends on more than the price movement itself. The size of the position determines how much each point of movement is worth, while trading costs reduce the net result. The trader therefore needs to consider not only whether the market is likely to rise or fall, but also how large the position should be and how much the trade will cost to maintain.
Examples why small-scale retail traders like CFD:s
- With a CFD, you do not need to buy an entire share to gain exposure to the share price. For small-scale traders, this is especially important when it comes to high-priced shares. At the time of writing, the share price of Apple exceeds 140 USD, Tesla hovers above 810 USD, and buying just one Amazon share will cost you more than 3 255 USD.
- Even when shares do not cost much individually, making a noticeable profit from buying and selling them can require a trader to buy a large number of shares. When price fluctuations are small, many shares are required to make a substantial profit. Using Contracts for Difference makes it possible to profit from small price movements without taking on ownership of a large number of shares.
- When prices are going down, Contracts for Difference are considered both easier and less risky than short-selling.
- Brokers that offer CFD:s tend to also offer large leverage.
- CFD:s makes is very easy to speculate on non-tangible things, such as the movements of an index.
- With CFD:s, you can gain exposure to a wide range of cryptocurrencies without having to own and transfer cryptocurrency. CFD:s are available for both crypto-crypto pairs and crypto-fiat.
The attraction for smaller traders is largely about access. A conventional investor might need a large amount of capital to build meaningful exposure to several expensive shares or different international markets. A CFD account can provide exposure to those markets without requiring the trader to purchase the full value of each underlying asset.
This does not mean that CFDs make expensive assets cheap in an economic sense. The trader still gains or loses according to the size of the underlying exposure. Leverage simply changes how much money has to be deposited as margin before the position can be opened. If a trader controls a large position with a small deposit, relatively modest market movements can have a large effect on account equity.
The ability to speculate on indices is another practical attraction. A stock index such as a broad national market benchmark is not itself one single share that can simply be purchased in the same way as a company stock. A CFD can provide price exposure to the index level without requiring the trader to buy every share represented inside it.
Leverage and margin
CFDs are commonly traded using leverage. Leverage means that the trader can control a position worth more than the amount deposited as margin. The broker requires only a portion of the total position value to be placed in the account before the trade can be opened.
For example, if a trader deposits 1 000 USD of margin and uses it to control a position worth 10 000 USD, a 1% movement in the underlying market changes the value of the position by approximately 100 USD before costs. The underlying asset only moved 1%, but the change is equal to 10% of the original 1 000 USD margin.
The same effect works in both directions. A profitable movement is magnified relative to the cash used as margin, but so is a losing movement. This is why leverage can make CFDs attractive and dangerous at the same time. It can increase capital efficiency, but it can also make ordinary market fluctuations financially painful.
Margin should not be confused with maximum risk. If 500 USD of margin supports a position worth 5 000 USD, the economic exposure is based on the 5 000 USD position rather than the 500 USD deposit. Traders who focus only on the margin figure can easily underestimate how much money is actually exposed to market movement.
Long and short positions
A long CFD position is used when the trader expects the underlying market to rise. If the price rises after the position has been opened, the difference can generate a profit. If it falls, the position generates a loss.
A short CFD position is used when the trader expects the underlying market to decline. The trader does not normally need to borrow the underlying share or commodity before opening the short position because the contract itself creates the exposure.
This can make CFDs convenient during falling markets. Traditional investors often think primarily in terms of buying assets that they expect to appreciate. CFD traders can move between bullish and bearish positions using much the same trading interface.
The convenience should not be confused with certainty. A market can reverse rapidly, and short positions can lose money just as quickly as long positions. The direction button changes, but the need for position sizing and risk control does not.
CFD trading costs
CFDs can involve several different trading costs. The spread is one of the most common. It is the difference between the price at which the broker allows you to buy and the price at which you can sell. A position normally begins at a small loss equal to this difference.
Some brokers also charge commission, particularly for share CFDs or account structures where the quoted spread is very small. A narrow spread does not automatically mean low total cost if a separate commission is charged each time the position is opened and closed.
Overnight financing can become important for positions held beyond the end of the trading day. Since CFDs are leveraged products, the broker can charge financing based on the full position value rather than only the amount placed as margin. A position that appears cheap to open can therefore become costly if it remains open for several weeks.
Slippage is another cost that does not always appear clearly on a fee table. If the market changes rapidly between the time an order is submitted and the time it is executed, the actual fill can be worse than the expected price. This is particularly relevant around important economic announcements and periods of low liquidity.
CFDs and day trading
CFDs became strongly associated with day trading because they make it easy to open and close positions quickly across many different markets. A trader can move from a stock index to a currency pair or commodity without buying the underlying asset in each case.
Day traders usually close positions before the end of the trading session. This can reduce the importance of overnight financing, although spreads, commissions and execution become more important because the trader can make many transactions in a short period.
A strategy targeting only a small market movement can be heavily affected by transaction costs. If the expected profit is only a few points and the spread consumes a large part of that movement, the trading method can look successful on a chart while producing poor actual results.
Frequent trading also creates a behavioural risk. CFD platforms make it easy to open another trade immediately after a loss. Without clear rules, this can lead to revenge trading where the trader increases activity or position size in an attempt to recover money quickly.
CFDs and swing trading
CFDs can also be used for positions lasting several days or weeks. Swing traders often care less about extremely small spread differences because their expected market movement is larger, but overnight financing becomes much more important.
A trader holding a leveraged index position for twenty nights can pay financing repeatedly. These charges can reduce the final result even if the market moved in the anticipated direction. Swing traders should therefore calculate expected holding costs before opening the position rather than treating financing as a minor detail discovered later.
Longer holding periods also expose the trader to overnight and weekend gaps. A company can announce unexpected news after an exchange closes, causing the underlying share to reopen at a much different price. The same problem can occur in indices and other markets following political or economic events.
Stops and risk management
Stop-loss orders are commonly used to limit CFD losses. A stop tells the broker to close the position when the market reaches a chosen level. This allows the trader to decide in advance where the original trading idea should be abandoned.
An ordinary stop does not always guarantee the exact final exit price. If a market moves quickly through the chosen level, the order can be executed at the next available price. This can make the realised loss larger than the amount initially planned.
Position sizing is therefore just as important as stop placement. A trader can determine the distance between the entry and stop, decide how much money can reasonably be lost and then calculate the position size from those numbers.
The amount of available leverage should come after this calculation, not before it. Starting with the maximum position allowed by the broker and then trying to find somewhere to place the stop reverses the normal logic of risk control.
Buying shares gives the investor ownership of part of a company. Trading a share CFD provides price exposure without that ownership. This difference matters more than it can initially appear.
A shareholder can usually hold fully paid shares without a daily financing charge simply because the investment remains open. A CFD trader can incur overnight financing for as long as the leveraged position exists. This makes conventional share ownership more naturally suited to long-term investing in many cases.
Shareholders can also receive voting rights and ordinary dividends. CFD positions can be adjusted to reflect dividend events, but the CFD trader does not normally become a shareholder.
CFDs can be more practical for short-term speculation because they require less capital upfront and make short exposure easier. The better instrument therefore depends on whether the objective is long-term ownership or short-term price trading.
CFDs based on stock indices
Stock index CFDs allow traders to speculate on the movement of an entire market benchmark rather than one individual company. This can provide broad market exposure through a single contract.
An index CFD can therefore be useful when a trader has a view about the general direction of a national or sector market but does not want to select one individual share. A trader expecting a broad market rally can open a long position, while someone expecting a decline can open a short position.
Index movements are often less dependent on one company announcement than single-share CFDs, but they can still move sharply after interest-rate decisions, inflation reports, employment data and major political events.
Commodity CFDs
Commodity CFDs can provide exposure to markets such as gold, silver, oil and other raw materials without requiring the trader to store or take delivery of the physical commodity.
This convenience is particularly obvious with products such as crude oil. Very few individual traders want barrels of oil delivered to them. A CFD provides a way to speculate on changes in the market price without dealing with physical delivery.
Commodity pricing can behave differently from share prices. Supply disruptions, weather, inventories, production decisions and geopolitical events can all cause rapid changes. Traders moving from stocks to commodities should therefore avoid assuming that the same strategy will behave identically in both markets.
Forex CFDs
Currency CFDs allow traders to speculate on exchange-rate movements without physically exchanging and holding large amounts of the underlying currencies. A trader can take a position on EUR/USD, GBP/USD or another currency pair through the CFD contract.
The value of the position changes as the exchange rate moves. Interest-rate expectations, inflation, economic growth and central-bank policy can all influence these markets. Major currency pairs can also move rapidly around economic announcements.
Forex CFDs are frequently leveraged, so even small changes in an exchange rate can produce a large percentage change in the funds used as margin. This makes careful position sizing particularly important.
Cryptocurrency CFDs
Cryptocurrency CFDs allow price speculation without requiring the trader to hold the digital asset directly. This removes the need to manage a cryptocurrency wallet or transfer coins between addresses.
The trader still faces market risk because cryptocurrency prices can move very sharply. Leverage can magnify those movements further. A market that is already highly volatile can become extremely risky when a large leveraged position is added on top.
The availability of cryptocurrency CFDs also depends on the broker and the laws or regulations that apply in the trader’s jurisdiction. A product being visible on an international broker’s website does not necessarily mean that every customer can trade it.
Background
Contracts for Difference emerged in London in the 1990s and their creation is typically credited to the investment bank UBS Warburg, and more specifically to Brian Keeland and Jon Wood who worked at the UBS Warburg office in London. Back then, the Contracts for Difference were a type of equity swaps traded on margin.
After becoming popular among big and mid-sized traders, the CFD:s eventually trickled down to the online trading platforms utilized by small-scale retail traders. Among the pioneering companies that helped making CFD trading mainstream we find Gerrard & National Intercommodities (GNI), IG Markets and CMC Markets.
By the early 00s, CFD:s were as popular as financial spread betting in the United Kingdom. Financial spread betting had arose chiefly as a way to gain exposure to share prices without having to pay the British stamp duty on share transfers, and the CFD:s offered that same advantage to British traders. There was a big difference though: financial spread betting was considered betting, not trading or investing, and was thus not subject to capital gains tax on profits.
The early institutional use of CFDs helped establish many of the characteristics that remain important today. They could provide market exposure without transferring ownership of the underlying shares and could be traded on margin, making them useful for sophisticated market participants wanting flexible exposure.
Online trading changed the market considerably. Once brokers began offering CFDs through web-based platforms, individual traders could access instruments that had previously been associated much more strongly with professional financial institutions. Lower minimum account sizes and smaller trade sizes reduced the amount of capital needed to participate.
This broader access also increased the number of inexperienced traders using leveraged derivatives. The same product that can be useful to a professional hedging a portfolio can be extremely dangerous to a retail customer who treats margin as though it were the total amount at risk.
The UK Energy Act of 2013
One example of how well-known and accepted CFD trading has become is the UK Energy Act of 2013. The UK Energy Act of 2013 stipulates that Contracts for Difference (CFD:s) is to progressively replace the British Renewables Obligation scheme. The aim of these new CFD:s is to support new low carbon electricity generation in the United Kingdom (bot nuclear and non-nuclear).
In the new system, CFD reverse auctions are carried out to give investors the opportunity to easily invest in low carbon electricity generation. CFD:s are also agreed on a bilateral basis, such as the Hinkley Point C nuclear plant agreement.
The CFD:s fix the prices received by low carbon generation, to ensure that eligible generation will have a dependable income flow. The aim is also to reduce costs by fixing the price consumers pay for low carbon electricity.
The CFD scheme is funded by the Supplier Obligation, a levy on all UK-based licensed electricity suppliers.
Despite sharing the same name, these electricity-market Contracts for Difference serve a very different purpose from the leveraged trading CFDs offered by online brokers. In both cases a contract is used to manage the economic difference between prices, but the context, participants and objective are different.
The electricity scheme is intended to provide revenue certainty for qualifying low-carbon generation. A reference price for electricity is compared with an agreed strike price. The resulting difference influences payments between the generator and the relevant counterparty under the scheme.
If the market reference price is below the agreed strike price, the structure can provide additional revenue to the generator. If the market reference price rises above the strike price, the payment direction can reverse. This reduces part of the price uncertainty faced by developers considering major long-term electricity projects.
The shared terminology can confuse readers because a retail trading CFD is normally used to speculate on financial market prices, while the electricity-market CFD is part of an energy policy mechanism. The contract structure provides the similarity; the practical use is very different.
CFDs are contracts, not assets
The point that should remain clear throughout is that a CFD is a contractual claim rather than ownership of the underlying asset. If you trade a CFD based on a stock, you own the CFD position rather than the share itself. If you trade an index CFD, you do not own the companies represented by the index.
This places importance on the broker or other counterparty. The value of the contract can depend on the underlying market, but the account itself exists through the provider. Traders therefore need to consider both market risk and counterparty risk.
A correctly predicted market movement can still produce a disappointing result if trading costs are high, execution is poor or the contract terms contain conditions the trader did not understand. Reading the terms before opening the position is therefore just as important as analysing the underlying market.
Who are CFDs suitable for?
CFDs are primarily suited to active traders who understand leverage and want flexible exposure to movements in financial markets. They can be useful for day trading, swing trading and short-term hedging.
They are generally less natural for passive investors who simply want to own assets for many years. A long-term investor can often avoid recurring financing costs by purchasing the underlying asset directly rather than maintaining a leveraged derivative position indefinitely.
New traders should be particularly careful because CFD platforms make complicated financial exposure look simple. Clicking buy or sell is easy. Calculating total exposure, margin usage, financing and realistic loss potential takes more work.
The best reason to use a CFD is that the contract structure fits a clear trading objective. The weakest reason is simply that the broker makes large amounts of leverage available.
Understanding the risk before trading
CFDs can provide useful access to markets, but they should be treated as leveraged speculative instruments rather than inexpensive substitutes for conventional investing. Small margin requirements can hide large market exposure, and repeated trading costs can reduce returns over time.
Before opening a position, a trader should know the full notional value of the trade, where the position will be closed if the market moves against it and how much money can realistically be lost. Financing should also be considered if the trade might remain open overnight.
The underlying market remains the most important driver of profit and loss, but the structure of the CFD determines how that movement reaches the trading account. Understanding both parts is necessary.
A CFD can make market access easier. It cannot make the market itself easier to predict.