What is contract for difference (CFD) trading? Is it safe?

Summary

• Contract for difference (CFD) trading is a way to speculate on financial markets without any need to purchase or sell underlying assets such as shares, forex, indices, and commodities.
• Under a CFD contract, a buyer must pay the seller the difference between the current value of an asset and its value at contract time.
• The main reason why CFD trades are carried out is that it provides an opportunity to profit from price movements without owning the underlying assets.

Contract for difference (CFD) refers to an agreement in which a buyer must pay the seller the difference between the current value of an asset and its value at the contract time. CFD provides a way of trading which involves speculating on financial markets without any need to purchase or sell underlying such as shares, forex, indices, and commodities This trading strategy is basically used to short trades, leverage, and hedge.

CFD offers an opportunity to profit from price movement without any requirement to own the underlying assets.

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How do CFDs work?

CFD is considered an advanced trading strategy which is mostly used by experienced traders. This kind of trading does not require delivery of physical goods or securities. A CFD trader is not obliged to take ownership of the physical goods or securities. He only receives revenue based on the asset’s price change.

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For instance, a trader can just speculate on whether the price of copper would go up or down at the contract time. Thus, CFD involves making bets on whether the price of the asset would surge or decline going ahead.

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In case of the asset price increasing at contract time, the trader can offer his holding for sale. The net difference between the purchase price and sale price makes for the gain from the trades. The trades are closed through the brokerage account of investor.

Similarly, an opening position can be placed by a trader if he expects the value of the asset to drop afterwards. The trader now must buy an offsetting trade to settle the position. 

A few countries where such contracts are allowed include the United Kingdom, Germany, Switzerland, Singapore, Spain, France, South Africa, Canada, New Zealand, Australia, Thailand, Belgium, Denmark, and the Netherlands.

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In Australia, the Australian Securities and Investment Commission (ASIC), earlier in 2021, announced a few changes in the issue and distribution of CFDs to retail clients.

Key things to know

• A spread is known as the difference between the price of buying a CFD, and price of selling it.
• CFDs are traded in standardised contracts or lots.
• Unlike options, there is no fixed expiry period for CFD trades.
• Profit or loss = (Number of contracts x value of each contract) x (closing price - opening price)

Advantages of CFD trading

Lower margin requirements

Easy access to global markets

No day trading rules

Little or no fees

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Are CFDs safe to trade?

Before going ahead, you must know that CFDs are illegal in the US. Since CFD is an over-the-counter (OTC) product, it is not regulated by exchanges. The other concern is that use of leverage leads to a possibility of significant losses for traders. Thus, the US regulators are skeptical of the product.

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As already discussed, CFDs are not everyone’s cup of tea and are mostly used by experienced traders. There are several risks associated with CFDs such as counterparty risk, market risk, client money risk, and liquidity risk. Weak industry regulation, potential lack of liquidity, and the need to maintain an adequate margin due to leveraged losses are other concerns.

Thus, traders should carefully evaluate the pros and cons of CFD trading before taking the plunge. According to experts, having to pay spreads can be costly to enter and exit positions in case of large price movements in a volatile market.

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