Contract For Difference

What is a CFD?

CFD stands for Contracts For Difference, which is a derivative product that is traded, where you trade the changes in the prices of stocks and shares.

For example, if you buy a CFD on a stock that is $5.00 and the price rises to $5.50, then you profit from that change in price. So if you bought 1000 CFDs of that stock, then your profit is $500, minus costs. That is, the value of the CFDs mirror the underlying stock prices, and you can profit on this movement. You can just as easily short sell CFDs as well, and therefore profit from falling markets.

The reason why CFDs are a popular trading product, is that they are traded on leverage, and the leverage is typically 10 to 1.

With some providers this can be 20:1, but the amount or margin required typically varies with the individual CFDs.

What this means is that a trader with a small float can produce larger trading results from trading the stock market by using CFDs. All the trading results are magnified however, so if your system produces a certain sized loss in 1 year with no leverage, then this will be multiplied if you do use leverage.

So leverage should be fully understood and used with responsibility.

If you're new to CFD trading, see this CFD trading tutorial that will actually go through an example trade, including a the transaction costs of CFD trading, position sizing, and definitions of order types.

See this page to find out more about what is Contract For Difference, how they came about, and their status now after the GFC of 2007-8.

So the advantages to CFD trading are:

Leverage

This can magnify the results of a CFD trading system or strategy by an amount related to the leveraged used.

For example, if the margin requirement by the CFD provider is 10%, this means that with $5000 of funds, you can enter into for example $10 000 worth of CFDs (assuming a use of 2 to 1 leverage) and upwards depending on how much leverage is used. If you have a system that without leverage produces a certain return and drawdown percentage, then with leverage, you will produce both a magnified profit and drawdown.

See this discussion on using leverage when trading Contracts for Difference including what to watch out for when trading CFDs.

Go short CFD as well as long

You can with ease go short on CFDs as well as long.

Depending on your CFD broker or provider, you may be able to short the majority of their CFDs, with other providers, you can only short a portion of their CFDs. Being able to do short trades significantly increases the profitability of many trading systems, as you’re able to profit from both falling stock prices, as well as rising stock prices. You can profit from a bear market, not just during a bull market.

See this discussion here for more about short trading, and various short trading strategies with CFDs and stocks and shares and the recent debacle over the ban of short trading in 2008 - 2009 during the GFC (global financial crisis).

CFD Brokerage

The brokerage of commissions on CFDs are often less than that of traditional share or stock trading.

Brokerage is the cost of placing trades with your broker, and can be higher of lower with different providers.

But the cost of trading is also related to spread as well, which depends on whether you are trading DMA or non DMA CFDs.

See this page for more about CFD brokerage and what affects the costs of trading cntracts for difference.

Trade shorter time frames

Because of the leverage available, and the ability to short CFDs, you can trade smaller moves in the underlying stock prices.

This means that you can profit without needing to hold onto positions for a long time frames. For example, you can trade systems where you’re in trades for a few days to a few of weeks, instead of needing to be in positions for many months with some stocks to get a decent return. Remember that you will need to overcome the the fixed costs of trading (commissions).

The equity curve of a combinsed system is therefore potentially smoother and more consistent.

Find out more about day trading with CFDs here on this page.

Automatic stop losses

Unlike stocks, you can place automatic stop losses for CFD positions on your CFD trading platforms. This can help in two ways.

Firstly, they will allow you to exit a trade automatically “intraday”, rather than looking at the end of the day to see if the stock price has gone past your stop loss, before exiting the next day. This often improves the profitability of systems as it avoids this kind of slippage. Another words, it doesn’t let your losses run, which is important. Secondly, automatic stop losses make it easier for traders to follow a mechanical system, as the exits are done automatically, not at your discretion, which again, will improve your profitability, assuming you’re trading a profitable system.

Find out more about backtesting CFD trading systems here on this page.

You can place all your orders in the evenings

For many people who are not available to check the computer screen during the day, trying to place trades when the market is open, and exit them during the day can be near impossible.

So this is another reason why CFD trading is the instrument that makes it possible to trade a system, by trading only in the evenings.

With many CFD providers, you can place all your trades in the evenings when the market is closed (in fact usually anytime of the day or night). That is you place your orders to enter a CFD, as well as your "if done" stop loss order, all at one time, and you will not be required to look at the computer screen during the day to trade. The trading routine will take less time.

See this article on the steps to contracts for differences trading and the 3 common mistakes to avoid.

There are at least two types of share and stock CFDs, namely market maker CFDs or DMA or Direct Market Access CFDs or contract for difference, and more recently a third type of CFD, the Exchange Traded CFD.

Click here for a complete list of CFD trading articles, and also for the latest CFD trading news.

Also, you can also see this blog on CFD Trading.