CFD (Contract for Difference)

A CFD (contract for difference) is a derivative: an agreement between a trader and a provider, usually a broker, to exchange the difference in the price of an underlying asset between the time a position is opened and the time it is closed. The trader never owns the underlying asset itself; the contract simply tracks its price movements. CFDs are therefore not traded on a stock exchange but over the counter (OTC), with the broker typically acting as the counterparty.

CFDs are available on many underlying assets, including shares, stock indices, commodities and currencies. Thanks to leverage, they make it possible to trade these markets in both directions with relatively little capital: traders buy (go long) if they expect prices to rise and sell (go short) if they expect prices to fall. The same leverage, however, also magnifies losses.

How does CFD trading work?

The profit or loss of a CFD position is the difference between the opening and closing price multiplied by the position size. Example: a trader buys CFDs on 10 shares of a company at $100 each, so the position is worth $1,000. If the price rises to $105 and the trader closes the position, the gain is 10 × $5 = $50. If the price falls to $95 instead, the loss is $50. With a short position, it works the other way round. On top of this come trading costs, such as the spread, in some cases a commission, and financing charges for positions held overnight.

What is the leverage effect?

Leveraged financial products such as CFDs allow traders to use the leverage effect to increase the return on the capital they put up. Only part of the position's value has to be deposited, while the position is traded long or short at a fixed ratio, for example a leverage of 1:4 (often also written as 4:1).

For a share priced at $100, a leverage of 1:4 means that only $25 of capital is required. This is where a common misunderstanding arises: beginners often see leverage as a way to trade four times as many shares with their $100. In doing so, they also quadruple their risk of loss. Experienced traders tend to use leverage in this example to tie up less capital: instead of $100 for one share, only $25 is needed.

Even then, the risk is based on the full position of $100: if the share price falls by 10%, the loss is $10, which is 40% of the $25 deposited. A fall of 25% would wipe out the entire amount.

Margin and the risk of rapid losses

The amount a trader has to deposit to open a position is called the margin. The higher the leverage, the lower the margin, and the smaller the price movement needed to wipe it out. With a leverage of 1:20, a 5% move against the position is enough to lose an amount equal to the entire margin; with 1:100, a 1% move is enough.

If losses reduce the account equity below the required level, the broker may issue a margin call asking the trader to add funds, or close positions automatically (stop-out). In fast-moving markets, for example after important economic news or when prices gap over the weekend, prices can jump past a stop-loss order, so losses can be larger than planned. Depending on the provider and the applicable rules, losses can even exceed the money in the account. In the EU and the UK, retail clients have been protected against a negative account balance since 2018, and leverage for retail clients is capped there; many other regulators also limit leverage.

What should traders keep in mind?

CFDs give traders access to many markets from a single account, allow them to profit from falling prices as well as rising ones and can be used to hedge existing positions. At the same time, they are complex, high-risk products, and regulators in many countries require providers to warn that a large proportion of retail investor accounts lose money when trading CFDs. Anyone trading CFDs should fully understand how leverage works, only risk money they can afford to lose and apply consistent risk management, for example by limiting position sizes and using stop-loss orders. Profits are never guaranteed.