Contracts for difference (CFDs) emerged in the 1990s, originally created to allow investors to benefit from share price movements without actually owning the assets.
The term CFD “Contract for Difference” is attributed to Brian Keelan and Jon Wood, who introduced this financial instrument in the UK in 1990.
The history of CFDs is closely related to the evolution of financial markets and technology.
The idea was to provide a more flexible way to trade by removing the need to own the asset. In a CFD, the investor does not actually buy or sell shares or other assets, but bets on the future direction of prices.
CFDs have opened up opportunities for speculation on a wider range of assets, including stocks, indices, currencies, and commodities, but trading involves significant risks and investors can lose more than the initial amount invested.
What are CFDs and how have they evolved in the financial world?
Contracts for Difference (CFDs) are financial derivatives that allow investors to profit from price fluctuations in underlying assets without actually owning the assets.
But what exactly are CFDs and what do they mean? They are contracts entered into between two parties, the buyer and the seller, and establish the exchange of the difference between the opening price and the closing price of an underlying asset.
Contracts for Difference (CFDs) have evolved significantly in the financial world since their emergence in the 1990s. Here is a look at the evolution of CFDs:
- The 1990s – the birth of the concept
CFDs were first created in the UK in 1990 by Brian Keelan and Jon Wood to give investors a way to speculate on share prices without actually owning those shares.
- The 2000s, – global expansion
CFDs grew in popularity around the world in the 2000s, and these instruments have expanded to include a diverse range of assets such as indices, commodities, and currencies.
- 2000s – online trading platforms.
The development of technology and the popularization of the Internet have led to the emergence of online trading platforms, providing investors with easy access to CFD trading.
- 2010s – regulation
As the popularity of CFDs continued to grow, so did regulation from financial authorities. The aim was to protect investors and ensure a more transparent and secure environment for CFD trading.
- The 2010s – diversification and innovation
CFD offers have diversified and included more asset classes, and financial instruments have become increasingly complex. Options and other derivatives have also emerged.
- Currently – leverage and risk management
Strict regulations on the use of leverage have been imposed in some jurisdictions to protect investors from excessive risk. Risk management has become an essential aspect of CFD trading.
- Currently – trading cryptocurrencies
Some CFD trading platforms have started to offer cryptocurrency options, thus expanding the range of available assets.
- In the future – blockchain technology
With the development of blockchain technology, there is interest in bringing more security and transparency to CFD trading.
- Future – Ongoing Regulation
Regulation is expected to remain central to the evolution of CFDs, with a focus on investor protection and prevention of excessive risk.
The evolution of CFDs reflects changes in the global financial environment, adapting to new technologies, regulatory requirements, and investors’ needs. It is important to monitor market developments and adapt to changes to stay informed and make informed trading choices.
What are CFDs in terms of instruments?
Let’s take an example of the tools that an investor can use to trade gold, which is part of the commodities category, and see what the most popular tools of the markets would be:
- to buy gold as such, physically (main market),
- buy or sell gold futures (derivatives category)
- buy or sell gold option contracts (derivatives category)
- invest in shares of gold-based ETFs (derivatives category)
- to invest and trade gold through contracts for difference, CFDs (derivatives category)
So investors can trade and invest in the main markets directly, or through derivatives that allow them access to these markets, such as CFDs.
CFD what it means by type of player
Depending on the time of transactions, we can classify the participants as follows:
- Scalpers. They are in and out of the market within seconds or minutes.
- Day traders. Make full trades within the same day.
- Swing traders. Capitalize on the basis of the trend reversal technique, a position lasting a few days, up to a week.
- Positional Traders (Positional Traders). They have a long-term view, have positions open for at least a few months, and can go beyond a year.
- Investors. Adopt the “buy-and-hold” strategy.
Considering the time spent by each category on the market, we can say that CFD is used more by those who open and close positions for not very long periods of time. The danger of unfavorable developments is the cost of maintaining the position.
What are CFDs?
Contracts for difference (CFDs) are financial instruments that allow people to speculate on the price movements of various financial assets, such as stocks, indices, commodities, or currencies, without having to actually own those assets.
Instead of actually buying or selling an asset, a person can enter into a contract (CFD) with a broker to speculate on the direction in which the price of that asset will go. If the price goes up, the investor wins, and if it goes down, he can lose.
In the case of CFDs, the investor does not have to actually own the shares or other assets. CFDs simplify the process, allowing them to take advantage of market movements without having to buy or sell the respective assets.
Investors can use leverage, which means they can control a larger position than they hold in the account. They can also benefit from margin trading, which allows them to open positions for less than the full trade value.
They offer the opportunity to make substantial profits, but they can also involve significant risks. If the market moves against the investor, losses can be greater than the amount originally invested.
Trading CFDs is complex and involves risks. Before starting to use them, it is recommended to inform yourself well.
Advantages and disadvantages of CFDs
Contracts for Difference (CFDs) are complex financial instruments that allow investors to profit from price fluctuations in underlying assets without actually owning the assets. Here are some pros and cons of trading with them.
Advantages of CFDs
- Leverage
The ability to use leverage allows investors to control a position larger than their account value. This can amplify both gains and, at the same time, losses.
- Diversification
Access to a wide range of financial markets such as stocks, indices, commodities, and currencies without having to actually own those assets.
- Trading in both directions
Ability to take advantage of both upward and downward price movements, providing flexibility in trading strategies.
- Lower costs
Trading costs are lower compared to actually buying the underlying assets because CFDs use leverage, but often only involve spreads and commissions.
- Margin trading
Investors can open positions with a fraction of the total trade value, which allows for more efficient use of capital.
Disadvantages of CFDs
- High risk
Trading CFDs involves significant risks. Investors can lose the entire amount invested and even more when using leverage.
- Volatility
Financial markets can be volatile and CFDs can be subject to sudden price fluctuations, which can lead to rapid losses.
- Financing costs
Long-term or short-term CFD trading may involve funding costs, which can affect the long-term profitability of a position.
- Complexity
Trading CFDs can be complex and understanding all aspects of this financial instrument can take time and expertise.
- Conflict of interest
CFD brokers may have an interest in losing investors because they can make money from spreads and commissions.
Consider both the pros and cons before you start trading CFDs, and adopt risk management strategies to minimize potential losses.
How does CFD trading work?
By trading CFDs, you are basically placing speculation on where you think the price of an asset will go.
Here’s how it works
Start CFD trading by choosing an asset you want to trade CFDs on. It can be stocks, indices, commodities, currencies or other financial assets.
After you have selected the asset, you need to decide whether you think the price will go up (long position) or down (short position). If you think the price will go up, you place a buy order, and if you think it will go down, you place a sell order.
You choose the amount you want to invest in CFD trading. You can take advantage of leverage to control a position larger than the amount held in your account, but you must be careful because it can amplify not only your gains but also your losses.
Once you place a trade, you monitor the evolution of the asset’s price. In CFD trading, it is advisable to add stop-loss or take-profit orders to manage the risk and fix the desired profit levels.
At some point, you decide to close the CFD trading. If you buy initially, you will sell to take a profit or limit losses. If you initially sold, you will buy to close the position.
The profit or loss is calculated based on the difference between the opening and closing price of the position.
You trade CFDs with risk management, using stop-loss orders and making informed decisions based on market analysis.
Technical and fundamental analysis in CFD trading
Let’s discuss how you use technical analysis and fundamental analysis in CFD trading.
Using technical analysis
- Identifying trends
Technical analysis involves examining price charts to identify market trends. You can use tools such as trend lines, moving averages, or price formations (such as head and shoulder patterns) to identify the overall price direction.
- Price map and price models
In technical analysis, you can use price charts and price patterns to identify trends and support/resistance levels. For example, uptrends or downtrends can provide clues about future price direction.
- Support and resistance
Identifying support and resistance levels can provide clues as to where the price might stop or reverse. Trading around these levels can be a common strategy in technical analysis.
- Candle formations
Certain candlestick patterns, such as “doji” or “engulfing,” can suggest trend reversals or changes in market sentiment.
- Use of technical indicators
Oscillators such as RSI (Relative Strength Index) or MACD (Moving Average Convergence Divergence) can provide overbought or oversold signals, helping you identify potential price reversal points.
- Price Patterns
Price patterns such as triangles, flags or double top/double bottom patterns can be used to predict future price movements.
- Trend lines and channels
Drawing trend lines or identifying price channels can help predict the future direction of price movement.
Using fundamental analysis
- Studying economic news and events
Fundamental analysis involves evaluating the economic and financial factors that can influence asset prices. Economic news, company financial reports, geopolitical events, and central bank decisions are essential.
- Financial reports of companies
In the case of stocks, studying a company’s balance sheets, earnings, and other financial reports can provide insight into its financial health. Track the financial results of the companies underlying the CFDs.
Earnings reports, revenues, and other financial data can provide clues about a company’s health and influence stock prices.
- Economic indicators
Macroeconomic indicators such as economic reports, interest rates, inflation, unemployment and GDP, fiscal policy, and others can influence market direction and provide information about the overall state of the economy.
- Geopolitical events
Events such as geopolitical conflicts or political changes can have a significant impact on financial markets. Major events such as political decisions, conflicts or economic changes can affect the financial markets and have a significant impact on the underlying assets.
- Dividends and Share Purchase Policy
For stocks, watch the dividend and share buyback policy as these can affect investor attractiveness.
Integrating both technical and fundamental analysis
Comprehensive trading strategies
Some traders combine technical and fundamental analysis to gain a more comprehensive perspective. For example, I can use technical analysis to determine the right time to enter or exit a position, and fundamental analysis to understand the underlying motivations behind price movements.
Risk management
Regardless of the type of analysis used, risk management is the key factor. Using stop-loss and take-profit orders can help limit losses and lock in profits.
Keep in mind that each trader may have their own approach and preferences regarding technical and fundamental analysis. It is recommended that you experiment and adapt these methods according to your trading style and financial goals.
It is important to combine both types of analysis in your decision-making process. Technical analysis provides clues to price movements and market sentiment, while fundamental analysis provides a picture of the asset’s financial health.
Holistic thinking and careful evaluation of both types of analysis can help make informed decisions in CFD trading.
CFDs in various financial markets
CFDs (Contracts for Difference) are available on a wide range of financial markets. The availability of CFDs on various markets may vary depending on the broker and the country in which you trade.
Here are some examples of CFDs in various markets:
- Actions
CFDs on shares of companies such as Apple, Microsoft, Google, Amazon, etc. You can speculate on stock price movements without actually owning those stocks.
- Indexes
CFDs on stock indices such as S&P 500, Dow Jones, FTSE 100, DAX, etc.
You invest in the overall performance of a market without buying all the stocks in that market.
- Currencies
CFDs on currency pairs such as EUR/USD, GBP/JPY, USD/JPY, etc. You trade on the price differences between two currencies.
- Goods
CFDs on commodities like gold, silver, crude oil, natural gas, etc. You benefit from commodity price movements without actually owning the goods.
- Cryptocurrencies
CFDs on cryptocurrencies such as Bitcoin, Ethereum, Ripple, etc. You trade on the price variation of a cryptocurrency.
- Bonds
CFDs on government or corporate bonds. You speculate on changes in bond prices.
- Options
CFDs on stock options or stock indices. Provides exposure to options without actually purchasing option contracts.
Examples of trading with CFDs
Let’s take an example where you decide to bet on the evolution of the price of gold. You have taken into account the technical and fundamental analysis and decided that you will bet on the price falling, so you will open a sell (short) position
The price of gold, at the time of opening the position, is 2000 USD. The leverage of the trading platform is 1:20 (5%).
- Initial investment:
You decided to sell 10 units of gold for $2000 per unit, so the total initial position value is $20,000 (10 units $2000/unit).
Due to the 1:20 leverage, you initially deposit $1,000 (5% of $20,000) to open the sell position.
- Price movement:
After a week, the price of gold drops by 0.5%, and from the analysis you made and taking into account your risk profile, you decide to close the position and mark the profit, or maybe you have already pre-set a take profit line and the transaction occurs automatically with your confirmation.
- Calculation of profit or loss:
The value of your initially open position is $20,000, and the price drop of 0.5% means a profit of $100 ($20,000 0.5%).
- Closing the position:
You want to close the position to collect the profit. The purchase price is $1990 per unit (down 0.5% from the original price of $2000).
The total value of the position at the time of closing is $19,900 (10 units $1990/unit).
- Calculation of final profit or loss:
We compare the initial value of the position ($20,000) with the closing value ($19,900). You made a profit of $100 on this trade.
- Calculation of profitability:
The $100 profit is calculated against the initial investment ($1,000 initially deposited). The return is 10% per week ($100 profit / $1,000 initial investment 100) or 520% per year.
So, in this example, after one week of trading by selling gold CFDs, you made a profit of 10% on your initial investment. As with buying, remember that trading CFDs involves risk and results may vary depending on market movements.
But let’s say you don’t want to take profit after a week, you redo the analysis, the signals are favorable and you decide to wait. You guessed right, after a month the price dropped by 3%, and the results would be:
- Initial investment, same as above:
You decided to sell 10 units of gold at a price of $2000 per unit, so the total initial position value is $20,000 (10 units $2000/unit).
Due to the 1:20 leverage, you initially deposit $1,000 (5% of $20,000) to open the sell position.
- Price movement:
After a month, the price of gold drops by 3%.
- Calculation of profit or loss:
The value of your initially open position is $20,000, and a 3% drop in price means a profit of $600 ($20,000 3%).
- Closing the position
You want to close the position to collect the profit. The purchase price is $1940 per unit (down 3% from the original price of $2000). The total value of the position at the time of closing is $19,400 (10 units $1940/unit).
- Calculation of final profit or loss:
We compare the initial value of the position ($20,000) with the closing value ($19,400).
You made a gross profit of $600 on this trade.
- Calculation of profitability:
The $600 profit is calculated against the initial investment ($1,000 initially deposited). The return is 60%/month ($600 profit / $1,000 initial investment 100) or 720% annualized.
So in this example, after a month of trading by selling gold CFDs and anticipating a 3% drop, you made a 60% profit on your initial investment.
Remember that trading CFDs involves risk and results may vary depending on market movements. What if the market does not evolve as you predicted, after a month you notice the upward trend and decide to activate the stop loss when the price has increased by 1.5%
You want to close the position to limit the loss. The purchase price is $2030 per unit (1.5% increase from the original price of $2000). The total value of the position at the time of closing is $20,300 (10 units $2030/unit).
We compare the initial value of the position ($20,000) with the closing value ($20,300). You recorded a loss of $300 on this trade. The $300 loss is calculated against the initial investment ($1,000 initially deposited). The return is -30% ($300 loss / $1,000 initial investment 100) or minus 360% per year.
So in this example, after a month of trading by selling gold CFDs and anticipating a drop, but the market went up 1.5%, you lost 30% of your original investment.
There is also the scenario where traders do not activate the stop loss, they hope that the market will come back. Most of the time they can be wrong.
In the above example, if after one month the price is 5% higher than the entry price, the trader loses all money, i.e. minus $1000 + brokerage platform commissions, and is notified that he will have to deposit more money if he wants to keep the position open or it is automatically withdrawn from the trading account.
Leverage and risk management in CFDs
As you can see in the examples above, leverage is like a tool in CFD trading and how it works can have a significant impact on your trades.
- Working method
When trading CFDs, you can use leverage to open positions larger than your equity. For example, with a leverage of 1:20, you can control a position 20 times larger than the amount you deposit (see also the examples above).
- Amplification of exposure
Leverage allows you to benefit from small price movements, generating potential gains greater than your initial investment.
- Amplified profit and loss potential
You must be aware that as you increase the potential for winning, so does the risk of loss. Losses can exceed the amount you originally deposited.
- Increased risk
Leveraged trading involves more risk. If the market moves against you, losses can quickly deepen and the broker may ask you to add funds or close the position.
- Risk management
It is crucial to carefully manage your risk and consider the margin requirements set by the broker. Thus, you avoid situations where losses exceed the amount of capital you have available.
- Fast effect
Leverage can make price movements faster, so be prepared for sudden changes and make sure you fully understand how it works.
It’s important to only take on the risk you’re willing to handle. Understanding its impact on your transactions is essential to making decisions that benefit you in the world of financial transactions.
Trading platforms for CFDs
- Plus500:
A well-known platform for trading CFDs on shares, indices, currencies, and commodities. The interface is friendly and suitable for beginners.
- IG Group
One of the largest and oldest online trading platforms. IG offers CFDs on a wide range of instruments, including stocks, indices, currencies, and cryptocurrencies.
- eToro
A social broker that allows trading of CFDs and also provides a social platform where traders can follow and copy the trades of other investors.
- AvaTrade
A platform that offers a wide range of financial instruments for CFD trading, including stocks, currencies, indices, and commodities. AvaTrade offers spot trading, mainly through MetaTrader 4 (MT4) and its own AvaTrader software.
- XM
A platform known for its online trading services, offering CFDs on currency pairs, indices, precious metals, and energy.
- Interactive Brokers
A platform suitable for advanced traders, offering access to a wide range of financial instruments including CFDs, stocks, options, and futures.
- XTB
A trading platform offering CFDs on stocks, indices, currencies, and commodities with a special focus on market education and analysis.
- CMC Markets
An online trading platform with a diverse range of CFDs including shares, indices, currencies, and commodities.
It is important to do further research and choose a platform that suits your specific needs, your level of experience and the financial instruments you wish to trade. Always make sure you choose a regulated and licensed broker.
Strategies for beginners and advanced CFD trading
Here are some strategies in CFD trading for beginners
- Go with the market (trend following)
When you trade CFDs, you try to follow market trends. Buy when the market is in an uptrend and sell when it is in a downtrend.
If the price goes in the right direction, you can take profit. Use simple indicators like moving averages to identify trend direction.
- Risk Management:
As we showed in the above example with gold CFDs, a small price movement in the opposite direction to your expectation can lead to the loss of your invested money. That’s why a crucial aspect of trading is risk management.
Don’t invest more than you can afford to lose and set clear limits on how much you’re willing to lose in a single trade. Use stop-loss orders to limit losses and take-profit orders to fix profit levels.
Advanced CFD Trading Strategies
- Trading against the current
Since many beginners would follow the trends, the contrarian strategy involves trading against the mass. That is, if many are selling, you can consider buying and vice versa. This is a more advanced strategy and requires a solid understanding of the market.
- Fundamental analysis
For the advanced, fundamental analysis involves examining the economic and financial factors that affect the price of the underlying asset. You can consider economic news, company financial reports and other macroeconomic indicators.
Use this information to anticipate market direction and make informed trading decisions. Although fundamental analysis is more suitable for experienced traders, this is not a fixed rule.
There are also beginners who can understand and successfully apply fundamental analysis to their strategies. Ultimately, the choice between fundamental and technical analysis depends on each individual’s personal preferences, trading goals, and investment style.
Remember that regardless of your experience level, it is always important to educate yourself and develop your own trading plan. Each strategy has its own risks and advantages, and there is no one-size-fits-all approach.
How can you start trading CFDs?
The CFD trading process involves several steps, from choosing a broker to managing open positions.
Here is a step-by-step breakdown of how CFD trading works:
- Choose a trading broker
Select a reliable and regulated CFD broker. You can find some of them in the CFD Trading Platforms chapter above.
Check the costs, trading facilities, available tools and reputation of the broker.
- Open a trading account
Complete the registration process and provide the required information.
Deposit the funds into the trading account using the methods accepted by the broker.
- Study and analyze the market
Analyze the underlying asset you want to trade (stocks, indices, currencies, commodities, etc.).
Use technical, fundamental or other strategies to make predictions about price movements.
- Choose the position direction and size
Decide whether you want to buy (long position) or sell (short position) a CFD.
Determine position size and use leverage if necessary.
- Open the position
Place an order to open the position through the broker’s trading platform.
Confirm trade details such as opening price and position size.
- Manage the position
It monitors the price evolution of the underlying asset.
It is advisable to add stop-loss or take-profit orders to manage the risk and fix the desired profit levels.
- Close the position
Decide when to close the position. Place a close order through the trading platform.
- Calculation of profit or loss
The profit or loss is calculated based on the difference between the opening and closing price of the position. You can also see the example given in the article, earlier.
- Manage risk
Don’t invest more than you can afford to lose. Use stop-loss orders and limit them according to your comfort with risk.
- Educate yourself continuously
Constantly learn about the markets, trading strategies and risk management to improve your trading skills.
Tips for beginners in CFD trading
Here are some useful tips for a beginner in CFD (Contracts for Difference) trading:
- Educate yourself understand
It starts with a solid foundation of financial literacy. Understand key terms and concepts related to CFDs such as leverage, margins, stop-loss and take-profit orders.
- Choose a reliable broker
Select a regulated and reliable broker. Check the reviews and make sure that the broker offers an intuitive trading platform and quality services.
- Set your goals and ways to manage risk
Set realistic financial goals and develop a risk management strategy. Don’t invest more than you can afford to lose, and set clear limits on how much you’re willing to lose in a single trade.
- Start small
In the beginning, start with a small amount of money. This gives you the opportunity to learn and get used to the trading platform without exposing significant capital to risk.
- Learn technical and fundamental analysis
Learn both technical and fundamental analysis. Both can provide different perspectives on the market and help you make more informed decisions.
- Be aware of leverage
Understand how leverage works and how it can affect your trades. Use them with caution to avoid excessive risk.
- Control your emotions
Trading can be exciting and stressful. Learn to keep your emotions in check and make rational decisions for long-term success.
- Follow the news and events
Stay up to date with economic news and market events as they help you anticipate price movements and make informed decisions.
- Practice demo mode
Most brokers offer demo accounts. Practice your trading skills in real market conditions, but without the risk of losing real money.
- Keep learning
Financial markets are constantly evolving, so be open to always learning and adjusting your strategies based on market changes.
Use these tips as a beginner’s guide and improve your skills as you progress into the world of CFD trading.
