CFDs are hugely popular, and hugely controversial, retail investment product. Their origins can be traced back to London in the late 1980s and early 1990s, where traders wanted to price in their views on the movement of the daily price fixes in gold. To do this they traded a product based solely on differences in price, with no requirement of either party to take possession of the underlying asset, allowing them to hedge risks elsewhere in their trading books with ease and flexibility. In the institutional market, similar products such as swaps (which exchange a cash flow, rather than a lump sum) have taken over the old function of CFDs, but CFDs have had a remarkable second life as one of the most demanded retail products in finance.
The delivery-free nature of CFDs made them uniquely suited to speculation, a trait that wasn’t lost during the first boom in retail trading in the late 1990s and early 2000s. CFDs first began to be marketed to retail investors during this period, with very mixed results, and some jurisdictions responded by banning the products outright, as is still the case in the United States. Where they are legal, CFDs tend to be very popular as they are simple to buy and sell, allow for leverage, and can be traded quickly with comparatively low fees. The well-known issues with CFDs – that most of their buyers lose money, and some a lot of money – do not detract from their genuinely useful characteristics, such as the ability to trade unusual risks, or hedge other positions with ease.
How do CFDs work?
In a CFD two counterparties agree to exchange a lump sum of cash based on the difference between the price of an asset on entering the trade (the strike price), and at the end of the contract. CFDs may be for a fixed term or may be open-ended, with the latter requiring one party to close the contract for the liability to close.
Imagine you and your broker enter into a CFD on Stock X, trading at $12.50. You are optimistic about the prospects of this stock, but don’t want to own it outright, so enter into a CFD where you will receive the positive price difference (or pay the negative) for future price moves. You expect the stock to increase to $20 and intend to sell once it reaches that price. If the price of X reaches $15.00, you will be owed $2.50 for every contract owned, assuming you own 100 contracts with a contract size of $20; $250 in profit. You may leverage this trade, perhaps at 10:1, which would mean you control 1000 contracts for the cost of 100; increasing your profits to $2500 (fewer fees). Of course, should the price fall to $10, you will owe the exact same amount, and if you have used 10:1 leverage, you may incur $2500 on an initial outlay of just $200 (this of course works in both directions).
For this reason, CFDs are best traded with extremely tight risk management practices, using a close-stop loss and constantly monitoring the market to ensure they have not moved against you. These are frankly dangerous financial products, and though they do offer outsized returns to some investors, the general performance of retail investors in this area is extremely poor, with the vast majority losing money.
CFDs and retail traders
CFDs initially became popular with retail traders because of their flexibility, and the offer of leverage. In some jurisdictions, there was also an initial lack of clarity about the legal status of CFDs and whether they constituted securities since neither party took delivery of the underlying. Unlike binary options, a product in some ways similar that ended up being regulated under gambling law rather than financial, the history of CFD use as a financial product between professionals helped ensure that it was eventually treated as a financial and not a gambling product.
The main difference between the CFD's historical use, where it played a similar function to the swap, a well-known financial product among institutional traders, and its modern use among retail traders, is the lack of a hedging requirement. Normally professional traders using swaps or CFDs did so because they were exposed to risk in price moves of a particular market, and required precise protection against those moves. This meant the CFD, with its customizable nature, was uniquely well suited to their needs and more importantly they had to buy them. This is quite different to speculative investors who buy CFDs because they are the most price-effective way to express a particular investment view and offer large amounts of leverage.
What sort of accounts are there today?
The best CFD trading account is the one that offers you the underlying you are interested in trading, with good charting software, far rates, and that offers the right amount of leverage. Be extremely careful with leveraged accounts as they will magnify both your winning and losing trades, which can swiftly become a problem when a run goes against you. Remember that CFDs are ultimately an agreement between you and your broker to exchange the difference between a start price and the finishing price of an asset; you need therefore to have confidence in the creditworthiness of your counterparty, making it preferable to trade with a large financial institution. Different accounts will have different fee structures that you should compare before buying, as this can have a significant impact on your eventual returns.
CFDs can be genuinely useful – for hedging against risks elsewhere in your portfolio, or for trading assets where taking delivery of the underlying would be unacceptable, such as certain commodities contracts. That said they are absolutely not a ‘classic’ investment product, and the vast majority of retail investors should steer well clear of them. If you do decide to jump into the world of contracts for difference, remember to practice proper risk management techniques