In recent years, Contracts for Difference (CFD) has gained significant attention and popularity in the financial markets. Around since the late 1980s, these financial derivative allow traders to speculate on the price movements of various products, including stocks, commodities, indices, and more, without owning any underlying asset. Retail CFD trading has steadily built up in popularity, and though it is popular for the flexibility of accessing different market risks, and for offering the opportunity to trade markets that are otherwise impossible, retail CFDs are a product that are difficult to master and come with considerable risks.
What are CFDs and what are their features?
CFDs are a contract made between two counterparties to exchange as cash the difference in price between an asset at the start of the contract (the strike price) and the end. CFDs may be fixed term or open ended, with investor P&L simply the difference between the strike price and the current market price. This structure allows for easy trading in either direction; traders may go long or short on any asset without recourse to complex methods such as buying options or short selling.
CFDs are closely related to swaps, a product by financial institutions to hedge risks linked to interest rates, and the first CFDs were traded between banks on the price of gold. With time, CFDs began to be marketed to retail clients as a day trading opportunity, and have since grown to be a major product in the retail day trading market.
CFD markets exist for every financial asset, including commodities, ETFs, stocks, indices, FX and cryptocurrencies. Because the agreement is made over the counter between two market participants, there is no need for centralised exchanges or for clearing – you simply enter the CFD contract and then exchange the price difference on exit.
CFDs are known for trading with high levels of leverage. Compared to other assets, it is normally possible to achieve greater leverage with CFDs, which can magnify both the gains and losses incurred while trading. Retail traders need to be extremely careful when CFD trading on margin, as it is possible for losses to mount quickly, incurring margin calls and losses.
One of the significant advantages of CFD trading is how they offer access to unusual markets. Many metals contracts or other commodities are difficult to trade without using forward or futures contracts that are cash settled, which is expensive and requires a significant minimum trade size, to avoid taking physical delivery of the commodity. Because neither counterparty actually holds the assets involved in CFDs, there is no risk of physical delivery and investors may benefit from price moves in these commodities without the difficulties of buying them outright.
What are some CFD trading strategies?
CFD trading strategies are the same as the various strategies used to trade their underlyings, with all the most common types represented.
- Technical Analysis: Charts, momentum indicators, and technical analysis play a significant role in CFD trading. Traders use candlestick patterns and technical indicators based on historical price data to identify potential entry and exit points.
- Fundamental Analysis: While CFDs don’t involve ownership of the underlying assets, fundamental analysis can still provide valuable insights. Traders can analyse economic data, company earnings reports, and news events to make informed trading decisions about the direction of the underlying asset.
- Scalping and Day Trading: Some traders employ short-term strategies like scalping and day trading to capitalize on small price movements within a single trading day, using momentum based indicators and mean-reversion strategies.
- Swing Trading: Swing traders aim to capture price swings over a more extended period, holding positions for days or weeks. These often rely on trend following strategies.
Managing CFD positions
It is very important to maintain impeccable risk management practices when CFD trading. Because CFDs are traded on margin, maintaining sufficient cash in your account is essential, as you do not hold any real underlyings to act as collateral. Position sizes should reflect this reality, and traders must not be afraid to exist loss-making positions. Strict adherence to stop loss levels is important to prevent unrealised losses growing out of hand, damaging your overall portfolio. Investors must also be sure to only use leverage within reason – it is possible to overextend CFD positions quite quickly, so great care is advised.
CFD trading hours will normally follow the market of the underlying. It will usually be possible to liquidate a position outside of market hours at the last traded price, since the counterparty is not compelled to go to the market to hedge positions, and neither side holds any underlying. It is in theory possible for CFD providers to hedge their open positions by buying the underlying asset, but it is normally simpler for them to sell an opposite CFD position, nullifying this possibility.
Traders should stick to CFDs based on markets they really understand. The price action of a CFD contract is determined by that of its underlying, so traders should be informed about the usual volatility of the underlying market. For example, a CFD on a major FX pair is likely to be far less volatile than one on a commodity or crypto asset, and your trading strategies must be adjusted to this reality.
CFD trading offers traders a diverse range of opportunities in global financial markets. CFDs allow traders to enter customised contracts on any underlying of their choice, accessing significant amounts of leverage while doing so. For many retail traders, CFDs are the only way of accessing unusual commodity markets or other assets with a high minimum buy-in or risk of physical delivery.
However, CFD trading comes with its share of risks due to market volatility and the impact of leverage. As always, prudent risk management policies including well-placed stop losses are essential to preserve your portfolio.