CFDs (contracts for difference) are a financial instrument that can help any investor to trade profitably even with little capital. But you need to study and prepare yourself to get the most out of this investment vehicle, avoiding the pitfalls and minimizing the risks of CFDs.
At the end of this article we hope to have motivated a future trader to materialize his dreams, but with his eyes wide open and with the tools and knowledge to make an adequate management of the risks implicit in contracts for difference.
To begin with… What exactly is a CFD?
CFDs are financial instruments of the so-called derivative products because their price is established according to the price of an underlying asset that can be an index, shares, futures or commodities, among others. The CFD is a contract between a trader and a broker who agree to exchange the difference between the entry price and the exit price of the underlying asset.
Imagine the following situation: You decide to “bet” on the upside with a friend on the price of Amazon shares. If the share price rises, your friend has to pay you the difference in price; if, on the other hand, the share price falls, it is you who pays the difference in price to your friend. Neither you nor your friend actually owns Amazon shares, but you will nevertheless have an exposure to Amazon’s share price equivalent to if you had bought Amazon shares (if the price goes up you make money, if the price goes down you lose money). In this example above you would be the CFD trader and your friend would be the broker.
So, if CFDs give us equivalent exposure to stocks, why not just buy stocks?
The quick answer is that CFDs give us much more flexibility and possibilities than investing in stocks. Let’s go into detail:
What are the advantages of CFDs?
With CFDs you can create short positions (bet on the downside)
CFDs allow us to do something that is impossible to do with other investment vehicles: We can take advantage of both the ups and downs of the market and the underlying assets. Contracts for difference allow us to invest in an asset in an inverse way, betting that the price of the asset will go down (a maneuver known as “going short” or “opening short positions”).
Imagine for a moment that we are at the beginning of the COVID-19 crisis. Global confinement measures have just been enacted and you quickly realize that these policies will wreak havoc on the global travel industry. How can you profit from this situation? Thanks to CFDs, you can open short positions on the main players in the global travel industry: Boeing, Expedia, Booking…
In this scenario above, thanks to CFDs, you would have been able to profit enormously in a bear market, something impossible to do with conventional stocks.
Wide variety of underlying assets you can trade with
Thanks to CFDs we have a wide variety of underlyings available, which means more opportunities for the trader. With CFDs you can not only trade stocks, but also commodities, precious metals, currencies…
Let’s go back to the previous example for a moment. You find yourself back at the beginning of this past global crisis, and you realize that confinement will also cause a drop in demand for oil by restricting people’s mobility. As demand falls, prices will fall, purely by the law of supply and demand.
In this situation, you decide to invest in oil (a commodity) by taking short positions. The price of oil plummets, and you manage to make money on this downward movement.
In short, thanks to CFDs, you have an infinite number of underlying assets to trade: cryptocurrencies, commodities (gold, aluminum, oil, sugar, flour…), stocks, currencies, geographic or sectoral indices (S&P, NASDAQ 100, Nikkei 225…), etc.
In addition, CFDs on stock indices, currency pairs or stocks with a high trading volume are highly liquid, which speeds up the execution of orders to open and close positions as it is easier to find a counterparty.
With CFDs you can trade with leverage
Thanks to CFD leverage, traders can invest larger amounts than they actually have. Leverage in CFDs allows us to literally multiply our exposure and profits; but beware, it is a double-edged knife with higher risks for the trader.
Let’s look at the advantages and risks of leverage with a practical example:
Imagine that you have $1,000 to invest in Amazon through a CFD. You are convinced that the share price will rise soon because the company will announce that, thanks to the lock-up, its revenues have increased.
You decide to open a long position (betting that the price will rise) with a leverage of 20x. That is, instead of investing $1,000 you are having 20 times the exposure: Your exposure will be the equivalent of $20,000.
Amazon announces that its profits have increased dramatically, and at the moment its share price rises by +15%. That is, you have just gained +15%, but not on your $1,000; but on $20,000. In other words: You have earned $3,000 (15% of $20,000) with an investment of only $1,000.
As you have traded with a leverage of 20x your profits are 20 times higher. Leverage seems so fantastic that it might seem unrealistic, doesn’t it?
Not so fast. With leverage you multiply your potential profits: but if the market moves against your position you can lose all your money in minutes.
In the example above, what would happen if Amazon’s stock price went down instead of up? Remember that you are trading with $1,000 leveraged at 20x, which gives you a real exposure of $20,000.
If Amazon’s share price were to go down by only -5% your balance would be $19,000 (-$1,000). As you would only have $1,000 to back your position – your collateral or margin with the broker – that fall would exhaust your collateral: As you would have no more money to back your position the broker would immediately liquidate your position and you would lose all your capital. (It is important to mention that with CFDs you will never lose more money than you have in your account: the broker will automatically liquidate your positions when you are unable to cover the losses).
Flexibility in trading hours
With CFDs we can trade intraday and take advantage of moments of volatility of the market or the underlying asset, as we can open and close trades on the same day and instantly without any limitation.
In addition, CFD markets have a much wider timetable (in many cases they are open 24 hours a day, although it depends on each broker) the 5 working days of the week.
For example, if we wish to buy “real” Apple shares, we can only do it when the New York Stock Exchange is open. On the other hand, if we invest in Apple through a CFD we will be able to do it with a much wider schedule, since we will be making a private contract with the broker that is not subject to market hours.
It is worth mentioning that CFDs have no expiration date, which means that you can keep your positions as long as you want and close them when you consider more appropriate.
Possibility of entering conditional orders
With CFDs we can open positions subject to certain market conditions. In a way, it is as if we can “program” our orders at our convenience. For example:
- Take Profit Order: Thanks to this option we can tell the broker to automatically close a specific position when profits exceed, for example, $500. In this way, if the market were to drop unexpectedly after a hypothetical rise, our profits would be assured.
- Stop Loss Order: Thanks to this option we can indicate the maximum we are willing to lose with a specific position before the broker closes it automatically. For example, if we open a long position (bullish) on Apple shares, we can set a stop loss of $50: Which implies that the broker will automatically sell if that position generates those losses for us. In this way, we limit the risk (maximum losses), but not the profits.
Although there are more complex conditional orders (such as One Cancel the Other, Dynamic Stop Loss, If Done or Buy Stop Limit, among others) the essential ones for any CFD investor are the 2 that we have seen in more detail a few lines above.
With CFDs you receive dividends
In case of dividend distribution, the long CFD investor keeps all the economic rights. That is to say, if you have a long position opened through a CFD at the moment when the company pays dividends, you will see how they automatically appear in the balance of your broker’s account.
If, on the other hand, you trade short, you will have to pay the corresponding amount of dividends out of your own pocket. The broker will automatically deduct any dividends the company may have issued from your balance sheet. Oddly enough, when a holder of long CFD positions receives dividends, it is because another trader with short positions (and not the company issuing the dividends) is paying them.
If you short large technology companies, which do not usually pay dividends , this will not be a problem. But if you decide to go short with companies with a tradition of paying dividends, it would be advisable to take into account their calendar to avoid having open positions on days when dividends are paid.
CFDs are very adaptable and flexible instruments
In many brokers if we want to invest in shares we have to buy a whole share, as not all of them allow investment in fractional shares (buying parts of a share).
In the case of CFDs, most brokers have very low investment requirements per position, in the order of $50. This allows us to invest in companies through CFD with very small amounts.
Thus, if we are operating with a small account (i.e. if we have little capital) CFDs allow us great flexibility. For example, with only $200, and if we have a minimum of $50 per position, we could invest in Amazon, Google, Apple and Facebook; something that would be impossible to achieve by buying shares through a “traditional” broker that does not allow the purchase of fractional shares.
How to trade CFDs with a reliable and regulated broker?
To trade CFDs, as you know, we need a broker with which to “establish” private contracts (i.e. contracts for difference on the desired products).
And precisely for this reason – and given that most brokers are market makers – it is very important that you operate with a broker regulated by international regulatory authorities, to ensure that the broker is audited and does not manipulate the markets in their favor.
When we buy and sell shares the broker has limited power over the transaction (it simply places our order to the market); but in the case of CFDs, as it is a private contract, the broker could manipulate prices or markets.
When it comes to CFD trading, the choice recommended by Investor Times is the broker eToro.com, an investment platform used by more than 20 million users, based in London and authorized by CySEC and the FCA (the UK regulator).
Another important point in eToro‘s favor is that it allows you to add funds to your account instantly by credit card, Paypal or bank transfer (among others).
In addition, eToro.com has successfully passed our audit process: This means that it has all the guarantees, security, reliability and liquidity standards that we require from a broker to successfully pass our high standards(and for you, as a trader, to have the best possible experience).
eToro.com is a leading regulated broker used by more than 20 million users worldwide.
Frequently asked questions about CFDs
Is it true that the broker is against you?
Yes, virtually all CFD brokers are to a greater or lesser extent market makers which means that you are their direct opponent. If you win they lose, and vice versa. However, this does not imply that the broker is your “enemy”: the broker’s main interest is, after all, that you remain his client.
But can I really make money trading CFDs?
Yes, of course you can! CFDs are one of the most widely used trading products in the world, allowing hundreds of thousands of traders to earn large amounts of money with them.
For this we recommend that you prepare yourself and only start trading when you are sure that, on average, you win many more times than you lose. Do not be one of those traders who, because they want to go too fast, lose their capital due to lack of experience. The inexperienced and uninformed trader commits harakiri without being induced to do so, just by entering the market without experience or planning.
What can the broker not do against me?
- A regulated and reliable broker will not distort the real prices to touch your stop loss. Most traders always put their stop loss where everyone else puts it and where they are sure to get swept. As long as you don’t make money you are losing your capital through no fault of your own.
- The same goes for when to buy and when to sell. Most inexperienced and unknowledgeable traders are champions at buying high and selling very low. That is why it is so important to study and practice, but also to experiment trading with real money and proper risk management, to achieve a methodology that allows you to win more times than you lose.
Summary: If you lose money with a CFD broker it is because you are trading wrong, not because the broker is deliberately hurting you. Yes, it is possible to make money by trading CFDs! Especially if you have little capital, but you must find your winning mantra through study, practice and perseverance.
Are CFD brokers cheap or expensive?
In finance it is said that there is no free lunch. The broker is going to make money because otherwise it would not exist. As for costs and spreads (the difference between the bid and ask price) this is what we can tell you:
- Apart from the commissions, and having to assume the real spread of the market, the broker can, and usually does, add an extra spread margin. It is recommended that this extra spread is kept within reason, as is the case with the broker eToro. It is advisable that the broker charges the minimum additional commissions, because this allows trading with small accounts without any problems.
- When there is volatility in the market, as a result of a major or unexpected event, brokers “play with the spread”. In situations like these, some brokers inflate their spreads to protect themselves and, as a result, orders are triggered that should not be triggered under normal conditions. It is understandable that brokers need to hedge in times of high volatility, especially predictable volatility. In fact, they often do so by announcing to all their clients increases in margin calls a few days before the event that may produce high volatility. For this reason, you should work with brokers that do not exaggerate the spread moments before the event and thus hurt you. eToro, the broker recommended in this article, is very reasonable in this regard.
- Swap commissions or interest for holding the position overnight. When you leave your CFD open for several days swap fees can be a significant cost. These interests depend on the Euribor plus a fixed rate, so if the rates are low they can be innocuous but you have to take it into account if you keep the CFD for many days.
What things should I know about leverage?
If you start CFD trading only to use leverage “greedily” and earn more, your capital will be very short-lived. The trading industry will sell you leverage as an opportunity to earn more. But, leverage, like weapons of mass destruction, can earn you a lot but it can also ruin you in one fell swoop if you don’t know how to use it. Therefore, if you are just starting out and do not have enough experience, we recommend trading CFDs without leverage, trying to get reasonable returns and controlling losses.
As soon as you have some experience, you will have the opportunity to progressively introduce leverage in your trading, controlling the risks and making a sensible management of your capital.
Can I trade CFD at any time?
The CFD trader can trade from Sunday at 22h until Friday at 21h, GMT time. Not all CFDs can be traded during this time window as it depends on the underlying asset. The timetable for trading CFDs is closely related to the policy of each broker, some respect the trading hours of the underlying asset and others allow trading even on Sundays. It is important to know the hours in which the different financial markets overlap, since in those overlaps the volatility and the volume of business is higher. The night is a good time to trade Forex as only the Asian market is active and its currency does not usually undergo large variations.
What is the next step to take after reading this article?
Get ready and practice with a free demo account such as the one offered by the regulated broker eToro. This broker offers completely free the possibility to trade with a demo account, with fictitious money, to test your strategies and capabilities.
Once you feel you are ready, start trading with CFDs and real money. But with humility, with small amounts, with planning and without greed.
Greed is your worst enemy, set reasonable goals for returns and you will succeed. Operate with eyes wide open and a cool mind, away from feelings. The rest is perseverance.