A CFD (Contract for Difference) is a financial instrument that mirrors the price of an underlying asset, such as a stock index, an individual stock, a currency pair, or something else. CFDs are also referred to as a derivative, meaning something derived from something else.
For instance, the value of a CFD based on Apple shares is a direct reflection of the price movement of Apple. Owning a CFD does not mean owning the underlying asset but a right to partake in the asset’s price movement on a one-to-one basis. If the CFD is leveraged, the price movement follows this leverage. Thus, it is relatively transparent to trade, for example, stock CFDs, as the price of the CFD follows the price of the underlying stock. Typically, 1 stock CFD corresponds to owning 1 share. However, CFDs often contain a leverage element, which ultimately causes a different development in the CFD’s market value.
A stock CFD based on Apple thus corresponds in market value to a regular share in Apple. If the price of the Apple stock rises by 5%, the value of the stock CFD will also increase by 5% (if one is long, i.e., has bought the CFD). If, on the other hand, the Apple stock falls, the value of the CFD falls correspondingly. If the CFD is leveraged with a factor of 5, it means that the total market value of the CFD rises 5 times as much, i.e., 25% or -25%, if the underlying stock falls. The leverage element is elaborated on below.
Broker as the counterparty
CFDs are traded with the broker as the counterparty. A CFD is issued by the trading platform (broker) on which they are traded. This means that it is the individual broker one trades with as the counterparty when buying and selling a CFD. For example, if one has bought a CFD from the broker Markets, it cannot be sold to anyone other than the broker itself. If one no longer wishes to own the particular CFD, one simply sells (i.e., closes) the position again with the broker. Thus, CFDs are not traded on a public exchange, such as a stock.
A CFD offers several advantages for those looking to speculate or trade in the short term, including the ability to bet on a given asset’s decline in value. This is done by shorting a CFD, which means opting to sell a CFD rather than buying it. When one buys a CFD, it is also referred to as going long.
Another advantage is that trading CFDs, which are typically based on leverage, allows one to stretch their money further since, at the opening of a position, one essentially borrows a predetermined amount from the broker. This, of course, also entails additional risk if the market does not move in the desired direction. More on this below.
Leverage component
One should be aware that CFDs often include a leverage component, but not always. It entirely depends on the individual trading platform. Leverage means that one can “speed up” their investment in the same way as, for example, mortgaging a property. Thus, a certain amount is deposited (a kind of down payment, typically referred to as a margin requirement or margin call). This is much like how one typically buys real estate with partial loan financing. The deposit constitutes a fixed percentage of what one is actually exposing themselves to (i.e., a percentage of, for example, the value of 100 Novo Nordisk shares). The rest is borrowed from the trading platform. Typically, the margin requirement for stocks would be 20% of the total value. This corresponds to a leverage factor of 1:5.
For instance, if one has opened a position in stock CFDs based on Apple consisting of 10 units (shares) at 178 USD each, the market value (exposure) totals 1780 USD. To open a position of this size, the broker typically requires a 20% margin, meaning one must have at least 356 USD in their trading account. This corresponds to a leverage of 5 times (1:5).
Different leverage factors
Other assets have different leverage factors. For example, if one opens a CFD based on an asset that is leveraged 1:30 (such as a currency pair) and has 1,000 USD in their trading account, they would be able to open a position with a market value/exposure of up to 30,000 USD. This would utilize all the money in one’s account for margin requirements. If one has opened a position with 1,000 USD in margin and the associated leverage is 1:30, and the market value of this position increases by 10%, one would earn 3,000 USD. Relative to the margin, this represents a 300% return. Thus, one can “go further with their money” when trading with leveraged products.
However, the risk increases correspondingly, which is crucial to consider in the investment decision. If the market value of the position falls by 10%, one would instead lose 3,000 USD. This means, in principle, one could have -2,000 USD in their account if they have not managed their position’s risk beforehand. By “in principle,” it is meant that as a retail investor, one cannot risk losing more than the funds in their account. Therefore, the broker will forcibly close your position before the account goes negative.
Leverage is thus two-sided, and the possibility of increasing one’s profit is correspondingly matched by the risk of increasing one’s losses. Partly because of the leverage element, CFDs are considered a complex financial instrument not suitable for everyone and require spending the necessary time to understand the instrument’s characteristics.
