Everything you need to know about CFDs

What is a CFD?

A CFD, or contract for difference, is a financial derivative product that enables traders to have exposure to the price movement of an underlying asset, such as stocks, without owning the asset itself.

CFD prices track the underlying asset's price, and trading CFDs offers advantages such as margin trading and typically immediate execution, as opposed to traditional stock trading on exchanges. It is important to note that CFDs are settled upon closure of the position, and trading costs can be spread based, commission based, or a combination of the two. Additionally, clients need to have funds to support the margin requirement to enter and maintain the position.

The price of the CFD is based on the price of the underlying asset, which can be stocks, indices such as the S&P 500 or DAX, commodities such as gold or oil, currencies, or a number of other assets.

What is CFD trading?

If you’re used to trading stocks, CFD trading will feel familiar. In its most basic form, a CFD (contract for difference) is traded like a stock. You buy a CFD, and when the price increases, you sell it at a profit.

But if you want to get into the details, a CFD is a contract between two parties that either increases or decreases in value, depending on the price of the underlying asset. CFDs are typically traded with leverage, making it possible to gain exposure to larger positions for a smaller initial investment. They are also traded directly over-the-counter (OTC) rather than on an exchange, which means there is counterparty risk.

To understand how CFDs work, let’s look closer.

How does a CFD work?

A contract for difference, also known as a CFD, is one of the most complicated financial products you can trade.

So what exactly is a CFD, and how does it work?

A CFD is a financial derivative product that allows traders to speculate on the price movements of different underlying assets (such as stocks, indices, commodities, or currencies) without actually owning the assets themselves.

So how do CFDs work?

Well, if you buy a single-stock CFD, you don’t buy the actual shares. Instead, you enter into a contract with a broker on the price development of the stock based on how you think the price of the stock will eventually move, up or down. The price of the CFD is based on the value of the underlying asset.

Next the broker will in turn source liquidity either internally or on exchange by buying the actual shares. So let’s say you open a long CFD position, expecting the price of the stock to move up, and then indeed the price increases, this means that the value of your contract increases accordingly – and you turn a profit. But if the stock price decreases, the value of the contract decreases, and you make a negative return- this is one of the risks when trading CFDs.

But even though there are risks, there are also two major advantages that CFDs offer over traditional stocks: leverage and shorting. CFDs enable you to increase your purchasing power because you can trade them on leverage. This means you only need to put up a fraction of the full value of your trade – the ‘margin’ – to gain full exposure.

When you buy stocks, you can only make a profit when markets rise. However, when you trade a CFD, you can speculate on price movements in either direction. If you think prices will rise, this is known as going ‘long’. And if you think prices will fall, this is known as going ‘short’.

So if you feel the share price of a stock will fall, you could ‘short’ it by selling a stock CFD. If you sell a stock CFD (assuming it is enabled for shorting), and then the company’s shares actually do fall in price, you can profit by buying the CFD back at a lower level and pocketing the difference between your entry and exit prices (minus the transaction costs).

There are many advantages and risks of trading CFDs, so it’s important to learn as much as you can about them so you can make the best decisions to help you reach your investing and trading goals.

Please note that there are costs associated with entering into a CFD position and exiting known as commission which should be considered. Additionally there is cost associated with holding a position short overnight known as the cost to borrow. Over 64% of retail investor accounts lose money when trading CFDs with this provider. You should consider whether you can afford to take the high risk of losing your money.

What are the advantages of trading CFDs?

While there is always risk when you decide to trade or invest in any instrument, there are some advantages of trading CFDs.

Two major advantages that CFDs (contracts for difference) offer over traditional stocks are leverage and shorting.

1. Leverage 

CFDs enable you to increase your purchasing power because you can trade them on leverage. This means you only need to put up a fraction of the full value of your trade – the ‘margin’ – to gain full exposure.

On most stocks, brokers offer leverage up to 5x (and up to 20x on stock indices). This means that with only EUR 2,000 in capital, you could gain exposure to EUR 10,000 worth of stocks. That’s 5 times what would be possible with a conventional stock trade.

Just remember that while this additional exposure can increase your potential profits, it can also increase your potential losses.

In the EU, regulation ensures that clients are awarded a degree of protection when trading CFDs. When entering a CFD order, clients must be able to meet the initial margin requirement which is higher than the maintenance margin (the required amount of capital available to keep the leveraged trade open). This prevents a client from being liquidated as soon as the position goes into negative P/L should the client attempt to use all available funds to meet a margin requirement.

2. The ability to go long and short 

When you buy stocks, you can only make a profit when markets rise. However, when you trade a CFD, you can speculate on price movements in either direction. This is known as going ‘long’ (if you think prices will rise) or ‘short’ (if you think markets will fall).

So, if you think the share price of a certain company is going to fall, you could short it by ‘selling’ a stock CFD. You can do this because CFDs are derivatives, and you don’t need to actually own any company shares to sell CFDs based on its stock.

If you sell the company’s CFD, and then the company’s shares fall in price, you can profit by buying the CFD back at a lower level and pocketing the difference between your entry and exit prices.

You may experience cases where a CFD is not available for short-selling. This might be because the broker isn’t able to borrow the stock. It may also be due to a short-selling ban put in place by the local financial authorities in order to protect the integrity and quality of the securities market.

It’s also good to know that when short-selling a CFD, you will be subject to the rules for the stock market in that particular market. For example, when short-selling CFDs, you may experience forced closure of a position, if the borrowed underlying shares get recalled. This may happen if the underlying stock becomes hard to borrow due to corporate events such as takeovers, dividends, rights offerings (and other merger and acquisition activities) or increased hedge fund selling of the stock.

Please also take note that short-sell orders with "good till cancelled" (GTC) or "good till date" (GTD) duration may be cancelled if borrow availability ceases. You may want to monitor short sell orders entered outside market hours or running across multiple days closely.

Lastly, always remember you may experience limitations on the amount of CFDs you can short trade in a single day due to limited borrowing availability in the underlying market.

Aside from those two key advantages of leverage and going long/short, CFDs offer a range of other unique benefits:

Access to a wide range of markets 

If you want to speculate on the financial markets, you don’t need to limit yourself to exchange traded products such as stocks and ETFs. Generally, you can trade CFDs on a much wider range of assets. At Saxo, for example, we offer CFDs on stocks, stock indices, forex, commodities, options, and bonds.

Around-the-clock trading

When you buy or sell shares, you are constrained by the opening hours of the corresponding stock exchange. That leaves you exposed to the risk of overnight price moves due to unexpected market events. You can trade CFDs whenever the underlying markets are open – stock CFDs for instance are available for trading when the associated stock market is open. However, CFDs on stock indices, such as the US 30 or Hong Kong 50, trade around the clock in tandem with the underlying futures contracts – so you can hedge or trade around events that take place outside official stock market opening hours.

Hedging

Another benefit is that CFDs can be used for hedging. This is done by selling short a CFD that is covered by a long stock position on the same underlying instrument. Let’s imagine you have bought a long-term stock position of a certain company. You believe that this company may, in the short-term, see its price decrease, but you continue to remain positive in the long term. In this case you can sell a CFD on the company equaling the size or part of the size of your stock holding to protect it against short-term price drops. You are hedged because the P/L of the CFD will offset the change in the P/L of the stock position. The intention is to buy the CFD back when the price is expected to rise again. Please note that trading costs must be considered (if these are large) versus the hedge's value.

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Are there risks with trading CFDs?

At Saxo we always want to be transparent with you about any possible risks when you trade. It is crucial for you to be aware that the value of CFDs (contract for differences) can go down as well as up. Losses can exceed deposits on margin products. And, as with other complex products, equity index CFDs come with a high risk of losing money rapidly due to leverage. In fact, over 64% of our retail investors lose money when trading CFDs.

To keep things as simple as possible for you, here is a list of what we at Saxo feel are the most important risks for you to be mindful of when trading CFDs.

1. Counterparty risk

CFDs are typically traded over-the-counter (OTC) with a broker, creating counterparty risk. This means that if a broker fails or becomes insolvent, financial losses are possible, so it’s important to consider the broker’s financial stability and choose reputable brokers.

2. Liquidation risk

When the funds available in the trading account are no longer sufficient to meet the margin requirement, the CFD broker will usually close all CFD positions. There is typically a soft warning (usually an automated alert, perhaps an email, from your broker) before the margin utilization gets to 100% to enable clients to fund the account if there is desire to maintain the positions open.

3. Gap risk and overnight cost

After-hours news may create a large price movement between previous close and the open. If this is an adverse price movement, a large loss will be reflected. It's also worth noting that holding long CFD positions overnight will incur funding charges based on the prevailing interest rates, and short CFD positions will incur a borrowing fee.

4. Volatility risk

The margin requirement may be adjusted with short notice when excessive volatility is experienced.

Other risks may include: regulatory risks (changes in regulation can affect CFD trading conditions), and psychological risks (for example, if refraining from closing a position because of bad trading discipline, there is a risk of mounting financial losses. Stops are a tool that can help manage this risk.)

Ultimately, the way CFDs work is that any returns will be amplified compared to the posted amount of capital, but losses may also be amplified. Traders must carefully analyze the market, and use risk management strategies. Saxo provides our investors and traders with risk-management features such as stop-loss orders.

Due to their flexible nature, CFDs can be used for more aggressive trading. To the less aggressive trader or investor, CFDs can be used for mitigating risk to exiting positions in times of market volatility.

So, before you trade CFDs, decide what you want to achieve with this investment vehicle. Always remember your personal investment goals (both short-term and long-term) and stay committed to your strategy.

What is CFD financing?

When you hold a CFD (contract for difference), you agree to settle the price difference between the price when you open the position and the price when you close the position. The required margin will get reserved on your account, but you do not pay anything up front. There may, however, be a transaction cost (commission), and potentially a financing charge should you keep the position open overnight.

Conversely, if you have a short position, you are credited/paid interest. If the position is held overnight, a borrowing cost will be applied to your short CFD positions. This borrowing cost is dependent on the liquidity of the stocks and may be zero for assets that are easy to borrow. Day trading incurs no financing charges.

How do underlying assets impact leveraging when trading CFDs?

With CFDs you can trade on leverage, which is when you put down a partial portion of the full value of your trade- the ‘margin’- to gain full exposure.

Leverage amplifies the effect of price changes on the underlying asset, and this will therefore magnify your profits and losses.

Leverage is expressed as a ratio- e.g., 1:10 or 1:50- which tells you the multiplier effect on your investment. With 1:10 leverage, for example, you can control a position worth 10 times your invested funds. That means you could invest USD 1000 in a stock CFD and control a position worth USD 10,000.

To open and hold a CFD position, you must have enough collateral to cover the margin requirements. On most stocks, Saxo offers leverage up to 5x (and up to 20x on stock indices). This means that with only GBP 2,000 in capital, you could gain exposure to GBP 10,000 worth of shares. That’s 5 times what would be possible through conventional share dealing.

How do CFDs handle cash dividends?

Because CFDs are such complex instruments, you may be wondering how dividends work when you trade them. The short answer is that because CFDs are derivatives, they do not receive actual cash dividends. However, there are fabricated dividends, or ‘cash adjustments’, which are made to reflect the economics of the corresponding dividend.

This adjustment is done on the ex-date for the CFD account, based on the eligible holding on ex-date-1 reflecting the market price movement on the ex-date. The actual value of the payment will be settled on pay date.

For long CFD positions, a ‘return adjustment’ is subtracted from the ‘cash adjustment’. The return adjustment is designed to mirror the cash-flow from the default withholding tax rate, in the relevant market for the underlying dividend payment.

For short positions – calculated entitlement will be debited on ex-date.

How to hedge with CFDs

Hedging is an advanced strategy, and you’ll need the right tools, such as CFDs to go short.

Hedging lets you offset the risk of one investment by taking out another investment. For instance, if you protect a stock position with the equivalent stock CFD, you’ll be positioned both long and short in the same stock- and any loss in one position will be automatically offset by a gain in the other.

Think of hedging like a form of insurance – it can reduce the negative impact from unexpected events during a volatile period, such as economic data events, geopolitical developments, or earnings calls.

So how exactly does hedging work with CFDs?

Imagine the clock is still ticking down to the closing bell. But rather than sell or just hope for the best, you’ve decided to hedge your position with a single stock CFD. CFDs are traded on margin, so you can easily take a short position and protect your portfolio while the market is volatile.

If your portfolio contains a lot of stocks from one index – say the Dow or the Hang Seng – and you think that volatility could hit all of your stocks at once, you can also short the entire index using an index-tracking CFD.

As a trader you can never avoid risk entirely- but by adopting a hedging strategy with tools like CFDs, you’ll have a safer net whenever risk is on the horizon.

Let’s look closer.

Why are CFDs a short-term strategy, not long-term?

CFDs are usually not used as a buy and hold strategy. Most CFD traders buy or sell CFDs for short term speculative trades because financing and borrow costs escalate over time. This makes them unsuitable for the long-term.

Where you can trade CFDs from

There are many countries where you can trade CFDs from, and some countries where you cannot (for example, the US Securities and Exchange Commission (SEC) has restricted the trading of CFDs in the US, but non-residents can trade using them). Keep in mind regulations change every day and restrictions may prevail, so if you are unsure if they are available in your country, check the product page to stay updated.

How to trade CFDs in the Saxo platform