What are CFDs and how do they work?
CFDs are a relatively new financial product that allow traders to make calls on the direction in price of a security such as a commodity or FX product. These products are extremely popular in the UK and across Europe, but they are illegal in the USA.
A CFD allows for heavy use of leverage. Normally investors need put down only a small fraction of the overall trade value when they open the position. Positions can be exited by entering into an opposing trade. Normally it is a bad idea to have a CFD position open outside of market hours. A sudden jump or fall at reopening – not an uncommon occurrence – could incur substantial losses.
CFDs are above all a short term product for speculators. They should never be used for longer term investing. This is because with the heavy permitted leverage the positions can rack up enormous losses. Also the lack of physical delivery means that the investor is left with a cash bill should the position move against them. For this reason they are not permitted in all jurisdictions.
Most successful CFD traders are day traders. They take out a CFD to express a view on the price of a particular product. Unlike short-dated options, CFDs do not include premiums and their price is easier to calculate.
What is CFD
The CFD is a contract between an investor and a financial intermediary. You are signing a contract to pay cash based on the change in price of the underlying. They are not exchange traded, though they often are traded according to market hours.
When an investor buys a CFD, they agree to pay the difference in price between the current value of the asset and the start price of the trade. Physical delivery of the commodity or currency is never taken. This allows for greater flexibility, and is particularly useful for trading on the price of a commodity. Given most investors cannot risk taking physical delivery for a commodity, for products like industrial metals these are one of the simpler ways of gaining exposure to price action.
Alternatives for accessing commodity markets include ETFs designed to track commodity price moves, and futures. FX traders can always buy the currency outright or use other products such as options of futures. CFDs are rarely used with equity holdings. Many investors appreciate CFDs because of the difficulties involved in shorting most products.
Asides from forex, where it is simply to take either side of a trade, short selling normally incurs considerable costs. Borrowing shares to sell back later at a profit brings fees and the costs deter all but the most committed retail investors. CFDs are one potential solution to this problem, though they should never be taken lightly.
The nature of the contract
It means that losses are in theory illimited. Furthermore, leverage can cause a build up of huge positions at great speed. Some regulators, such the US regulator, have banned them for this reason. The FCA in the UK instead limited the maximum leverage available to retail investors. Similar products like binary options have been banned. Previously some of these products were regulated by gambling authorities rather than the FCA, as they are technically bets on price moves.
Today this has changed and the UK CFD market is regulated by the FCA. This is good news for consumers as it places tighter restrictions on providers and offers you some security for your money. That doesn’t mean you should be complacent – scams still exist and you should never sign a contract you do not understand. Even with the new leverage limits the potential for major losses is still very high, unacceptably so for some investors.
Firms like Saxo capital markets have a broad range of CFDs investors can browse and select from. Using a reputable broker means you have the best chance of making a successful trade. When signing up to a new brokerage, be sure to check where they are regulated, as well as the range of products they offer. It is also useful to know how much leverage you will be entitled to.
In conclusion
CFDs are a useful product for short selling and expressing an interday view. They are also dangerous products, particularly when used with leverage. Always check your CFD broker is fully FCA regulated and compliant – this should be clearly marked on their website. If in doubt about any financial decision, check with a financial advisor.
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