CFD: A Comprehensive Guide to Contract for Difference Trading

CFDs, or Contract For Difference, are among the most widely used instruments by traders. They are gradually replacing trading with real assets. CFDs are derivative products that do not require the actual exchange of assets. This characteristic opens the door to very particular dynamics that profoundly affect the way of trading. In this article, we discuss CFDs, offering a guide that is as complete as possible. We will provide an overview of the instrument, describe the advantages and disadvantages, list the cases in which they can be used, and those (few) in which they cannot be used. Additionally, we will offer some advice to get the most out of this interesting tool.

A Definition of Contract For Difference

Contract For Difference are exactly what the name suggests: contracts. Specifically, contracts between the trader and the Broker. In this contract, those who profit do so on the difference between the price established at the time of purchasing the contract and the price established at the time of selling the contract. The price of what? The underlying asset, of course. CFDs are derivative products that have as their underlying the assets being traded: currencies, stocks, commodities, cryptocurrencies, etc. Contract For Difference, from being an "exotic" instrument at the beginning, are gradually becoming the norm. An increasing number of traders today prefer to invest with CFDs rather than with real traders. These dynamics are favored by two elements: one, CFDs really offer advantages; two, it is the Brokers themselves who favor the spread of CFDs, as it is a tool that is also convenient for them. Many Brokers, in fact, work exclusively with CFDs. In some cases, CFDs are the only way to trade without buying the asset, as in the case of cryptocurrencies. We will explain why in the following paragraphs. They are also the only way to enjoy decent financial leverage. This is a controversial aspect, because financial leverage itself is controversial, but we will have the opportunity to expand on the concept.

When Contract For Difference Can Be Used (and When Not)

There are cases in which it is possible to use Contract For Difference, then there are cases in which only Contract For Difference (or other similar instruments) can be used, or at least it is absolutely recommended. Finally, there are cases in which, unfortunately, they cannot be used. Let's start with the latter, in order to clear the field of the worst eventuality, which wastes the time of traders not accustomed to this type of dynamics. Well, Contract For Difference cannot be used when the Broker is not a market maker. A market maker is a Broker that places itself between the trader and the market: all orders that the trader issues are issued towards the Broker, who then relies on the market. Now, Contract For Difference by definition design an agreement, a transaction between trader and Broker. It follows that "non-market makers," which are technically called ECNs (Electronic Communication Networks), do not allow trading with some CFDs without making their own quotation of the products, but allowing users to negotiate directly at the market price. The cases in which it is almost or totally mandatory to use CFDs are two. The first is trading with stock market indices. Indices are simply parameters, they are not assets, so it is not possible to sell or buy them. No one buys or sells an index. However, it is possible to transform them into an underlying, so that a derivative follows its price. This is what happens with CFDs (and with other derivative instruments, of course). A similar, but not identical, discourse applies to cryptocurrencies. To be clear, it is possible to exchange real cryptocurrencies, to actually own cryptocurrencies or, conversely, to get rid of them. However, it is quite inconvenient as Exchanges impose significant commissions and exchanges suffer from a certain slowness. It is also potentially dangerous, as cryptocurrency thefts are not uncommon. Now, those who trade in CFDs have nothing that can be stolen, and benefit from almost immediate transactions. Trading with CFDs, if the goal is to profit from cryptocurrencies, is an almost mandatory activity.

The Advantages of Contract For Difference

In this paragraph, we give an idea of what it means to trade with CFDs, and why it is so convenient. In essence, we list the advantages.

• Speed. CFDs are "lighter" than real assets, even those that are digitized. Therefore, transactions are faster. In some cases, much faster. The reference is particularly to cryptocurrencies.
• Lower commissions. Since no CFD trader holds real assets, the costs are lower and the commissions are also lower. This is a significant advantage, since in some types of trading, such as bank trading, commissions represent a problem, as they seriously risk eroding traders' profits. In this case, commissions are not only low but can also be eliminated. Many Brokers, in fact, promote this "ultra-accommodating" policy.
• Higher leverage. For reasons of a technical nature that are complicated to explain here, CFDs are often accompanied by a more relaxed approach to financial leverage. We will delve into this topic in an upcoming paragraph.
• Wider offer. The possibility of using assets as an underlying, and not as an object of real exchange, allows Brokers to prepare a wider offer, which definitely benefits traders.
• Order guarantee. CFDs are granted by market mover Brokers and only by them. By definition, those who trade with market movers always have a guaranteed order, also because it is issued towards the Broker itself, and not towards the market.

The Disadvantages of Contract For Difference

Contract For Difference are not perfect instruments. After all, perfection is not of this world, let alone of a product linked to trading. The disadvantages, however, are far outweighed by the advantages. The biggest disadvantage, it may seem strange, is precisely the inability to hold real assets. If in most cases this represents an advantage, sometimes it can be a limitation. Think, for example, of cryptocurrencies, whose possession, in the event of an extremely bearish trend, can yield a lot. Another disadvantage is the need to manage the Broker in some way. Those who trade with CFDs must deal with a cumbersome presence, that is, with a Broker who does not merely act as an intermediary as with the ECN type, but "designs" the environment in which the trader operates, almost as if in a bubble. Now, all this is convenient, there is no doubt, but it imposes an extra attention on the trader. For example, on the pricing policy that the Broker adopts, and on the spread, which must be communicated with maximum transparency. Compared to other similar instruments, then, CFD trading suffers from overnight rates, which apply if a product is held for more than one day. An annoying toll, which can be considered a disadvantage, but which, if managed carefully, does not generate significant impacts. But, precisely, it is another aspect to watch out for.

The Difference Between CFDs and Futures

CFDs do not represent a unique instrument. In fact, similar instruments exist. The most important ones are Futures. In fact, on a scale that goes from the most "noble" or prestigious instrument to the one that has less of it, Futures precede CFDs. Also because, quite simply, they were born earlier.

What are the differences? Here are the most impactful ones.

CFDs are over-the-counter instruments, while Futures are part of a centralized market. This means that Futures traders, unlike CFD traders, can see prices, volumes, quotes, etc. In addition, Futures are issued by the centralized platform itself, they are "official," while CFDs are issued by Brokers. In turn, this aspect entails a different role for Brokers. In CFD trading, Brokers are market makers, while in Futures trading, Brokers are only intermediaries. Consequently, in CFD trading, commissions are lower (or absent), but spreads are higher; while in Futures trading, spreads are lower (or absent), but commissions are higher. Since the Broker does not have to take over the management of the derivative product, in Futures trading there is no overnight rate to be paid. On the other hand, the offer of Futures trading is more limited, as it does not include those assets that have not been fully accepted by supervisory bodies, such as cryptocurrencies. Moreover, the process of creating a CFD by the Broker is faster than the process of creating a Futures contract. Finally, with Futures, on average, the financial leverage is generally lower.

Some Advice to Get the Most Out of Contract For Difference

Trading with CFDs is convenient, but it is not necessarily easy... Quite the opposite. Like any speculative investment activity, it presents the bill, which is not only made up of lost money but also of study, commitment, and various difficulties. For this reason, it is absolutely necessary to follow these tips.

Don't get carried away by enthusiasm

Traders who come from a real investment activity may appear galvanized by access to so many assets (obviously as an underlying). This, in turn, could trigger a sense of euphoria, which is a very dangerous feeling when practicing trading, at all levels and with any instruments. Therefore, stop the enthusiasm: trading with CFDs offers some extra possibilities, but it is neither easier nor simpler than other types of trading.

Do not derogate from the rules of risk management

It follows that you must do exactly what you did before, not so much at the time of operation, which is indeed different, but in the previous phases (which are also the most important). The reference is to analysis, both technical and fundamental), and, even before that, to the execution of money and risk management techniques.

Do not overdo it with financial leverage

This is a fundamental piece of advice, to be followed without ifs and buts. The possibility of using high leverage is truly an opportunity, but it is also a double-edged sword. Always remember: with leverage, you multiply potential gains but also potential losses. Therefore, go easy, always act with knowledge of the facts. Do not opt for an immoderate use of leverage simply because, now, you can finally do it. The risk is truly to find yourself with the capital heavily cut or even close to zero.