CFD or “Contracts for difference” is a contract between a buyer (investor, trader) and a seller (investment platform), which stipulates that the buyer must pay the seller the difference between the current value of the asset and its value at the time of the contract (sale at a broker). CFDs allow traders and investors to profit from price movements (they can bet on downward and upward trends) without owning the underlying assets. The value of a CFD contract does not take into account the value of the underlying asset, but focuses only on the price change between the entry (buy) and exit (sell) of a given trade.
This is achieved through a contract (you enter into a contract with one button, don’t think it’s anything complicated) between the client and the broker. Trading CFDs offers several key benefits (but also risks) that have increased the popularity of these instruments for traders in recent years.
Some important facts about CFDs
- CFDs are for experienced traders, speculators and investors. It is definitely not a suitable tool for beginners, for whom this trading would be pure gambling!
- With CFDs there is no delivery of physical goods or securities.
- A Contract for Difference (CFD) is an agreement between an investor and an investment platform to exchange the difference in the value of funds between the time the contract is opened and closed.
- The CFD investor never actually owns the underlying asset but instead receives a return based on the change in the price of that asset. But that non-ownership is not important to the investor. For example, even when investing on Revolut you do not own the stock in question, which many people do not know.
- The advantages of CFDs include access to the underlying asset at a lower price than buying the asset outright (unless you can buy fractional shares from your broker, for example), ease of execution and the ability to mainly bet on a downward (shorting) or upward trend.
- The anticipated disadvantage of CFDs is the immediate reduction of the investor’s initial position, which is reduced by the size of the spread when entering the CFD. The fees for CFDs are higher for long term holding and for buying than for traditional buying with most brokers.
- CFDs are banned in some countries. The main ones include the USA. In contrast, CFDs are very popular in the UK, Germany, Spain, France, South Africa, the Nordic countries and Hong Kong. CFD trading is also growing in popularity in the Czech Republic.
What is CFD and how does it work?
A Contracts for Difference (CFD) is an agreement between an investor and a CFD broker to exchange the difference in a given financial currency between the time the contract is opened and closed. It is a contract for the movement of the price of a given instrument.
As we wrote above, it is a more advanced and risky trading strategy that is only used by experienced traders. A CFD investor never actually owns the underlying asset, but instead receives income based on the change in the price of that asset. For example, instead of buying or selling physical gold, a trader can simply speculate on whether the price of gold will rise or fall using CFD contracts.
In essence, investors can use CFDs to place bets and guess whether the price of the underlying asset or security will rise or fall. Of course, successful investors don’t do this based on emotion and mood, but on the basis of fundamental analysis and many sources of information
As already written, traders can bet on either an upward or downward movement. If a trader who has purchased a CFD sees the price of an asset rising, he will offer his share for sale. The net difference between the buy and sell price is counted as profit. The net difference representing the profit on the trades is settled through the investor’s investment account.
On the other hand, if the trader believes that the value of the asset will fall, an opening sell position, known as a short position, can be placed. The trader will realise a loss if the price of the asset goes up, but can realise a profit if the asset goes down. Shorting is simply investing in reverse, where you think the price of the asset is too high and will go down. CFD trading is ideal for shorting.
💡 TIP: CFD trading is particularly suited to more volatile assets where you can make a high profit if you trade correctly. Conversely, stable dividend titles are not traded much via CFDs.
Advantages of CFD trading
In this section we will look at five advantages of CFD trading.
1. Higher leverage
CFDs allow you to work with a lot of leverage where the trader does not need as much of his own money. CFDs provide higher leverage than traditional trading. Standard leverage in the CFD market is already subject to regulation. Previously leverage was possible up to 50:1 – so you could buy 50 times more than you had finance, now it is limited to a maximum leverage of 30:1 or 10:1. For a trader, leverage is a sign of less capital outlay per trade and higher potential returns. However, increased leverage can also magnify a trader’s losses, so in turn these trades create pressure for much better trade timing and prior investment analysis.
2. No day trading requirements
Some markets require a minimum amount of capital for day trading or place limits on the number of day trades that can be made within certain accounts. The CFD market is not bound by these restrictions and all account holders can trade during the day if they wish. Accounts can often be opened for as little as CZK 5,000, but for CFDs it is recommended to hold the account in dollars rather than crowns.
3. Access to the global market from one platform
Many CFD brokers offer products on all major global markets, allowing continuous access. Investors can trade CFDs in a wide range of global markets.
4. Diversity of trading opportunities
Brokers and investment platforms currently offer CFD contracts on equities, indices, forex, sectors and commodities. This allows speculators interested in a variety of financial instruments to trade CFDs as an alternative to exchanges. For example, the broker XTB provides very favourable conditions for CFDs.
5. Professional execution without fees
CFD brokers offer many of the same types of orders as traditional brokers ( today, you often have CFDs and classic share purchases with one broker), including stop limits and conditional orders. The broker makes money when the trader pays the spread. It is therefore profitable for the broker when the trader makes as many transactions as possible. The broker no longer cares if you make a profit or realize a loss. With CFDs, they also charge commissions or holding fees. If a trader wants to buy, he has to pay the ask price, and if he wants to sell or short, he has to pay the bid price. This spread can be small or large depending on the volatility of the underlying asset. Fixed spreads are also available in some places.
Disadvantages of CFD trading
After the advantages, let’s take a look at the disadvantages of CFD trading, which should be considered especially by newcomers.
1. You pay a spread on every trade
Although CFDs offer an attractive alternative to traditional asset trading, they also present potential pitfalls and risks. Having to pay a spread on entry (buying) and exit (selling) eliminates the opportunity to profit from small price movements. The spread also reduces winning trades by a small amount relative to the underlying security and increases losses by a small amount. Thus, while traditional markets expose the trader to fees, regulations, commissions and higher capital requirements, CFDs reduce trader profits through the cost of the spread.
💡 What is spread: Spread is the difference between the buying (ask) and selling (bid) price of a financial instrument (stock, forex, bond). When you buy an asset through a spread, you always start with a slight loss. The spread varies according to the type and volume of the trade. It is simply the fee you pay to the broker for making the purchase.
2. Risk of loss
CFD trading is fast paced and requires careful monitoring and knowledge. It is not like buying ETFs where it is an investment. With CFDs you are usually already an active trader. Otherwise you are taking a big risk with your finances. With CFDs you should know what you are doing. As a result, traders should be aware of the significant risks involved in trading CFDs. There are liquidity and margin risks that you have to maintain; if you are unable to cover the downgrades, your provider may close your position and you will have to cover the loss regardless of what subsequently happens to the underlying asset.
3. A reliable broker
The CFD industry is not as heavily regulated, so make sure you choose a broker that has been operating in the Czech market for a long time. The credibility of a CFD broker is based on reputation, length of operation and financial position. In the Czech Republic, XTB or eToro are well-established brokers.
4. Watch out for leverage
The risks of leverage expose you to greater potential gains, but also greater potential losses. Although many CFD providers have a stop-loss limit, no one can guarantee that you won’t suffer crushing losses very quickly, especially if the market closes or the price moves down sharply and then up again. Execution risks can also arise due to delays in trades and executions.
CFDs as an investment or making money online?
Yes, of course you can make money by trading CFDs. However, CFD trading is a significantly riskier strategy compared to other forms of trading and investing. Most successful CFD traders are experienced traders with a wealth of experience and tactical savvy.
There are many different gurus on the internet and Facebook who claim that with almost zero capital they can teach you how to trade CFDs and you will earn hundreds of thousands of crowns a month. This is of course not the case. They primarily want to extract money from you for initial training and nothing beyond that. If they were that successful they probably wouldn’t be selling courses and 100% how-to guides for market success. Trading is always a risk and CFD trading especially so.
If you’re interested in this subject, start with self-education first and when you’re ready you can step out. However, there are many easier and more guaranteed ways to make money online.
Also, be sure to try out a demo account with your broker or investment platform before you get off to a sharp start in the longer term. You should know and be familiar with all the principles and laws.