Understanding Contract for Difference (CFD)

As investing moves online, digital platforms offer CFDs as an innovative trading solution. CFDs have many similarities to traditional trading, but the differences make CFD trading popular and essential to next generation investing capabilities. Online CFD trading platforms, such as iToroStocks, allow retail investors:

• Access to multiple markets around the globe
• Currency and commodity trading
• Leveraged trading
• Low entry price trading
• Flexible long and short positions

CFDs are derived from futures contracts. A futures contract is an agreement between two parties, who agree on a price for a certain stock or commodity when opening the contract. Yet they complete, or settle, the actual transaction sometime in the future. CFDs do this in an easy and cost effective way. You don’t need large amounts of capital, or the expertise that institutional investors possess.

Instead, your trading can harness the power of technology, transparency, and crowd wisdom. CFD trading, which enables fractional stokes, flexible long and short positions, and is done in real-time, offers investors advantages that do not exist in traditional trading.

11.1 The History of Futures Trading

Early forms of futures contracts date back before the ancient Babylonians, some 3,800 years ago. The futures contract was created as a hedging tool. It enabled both parties in a transaction to protect their investment. At that time each contract was unique. It was arranged one contract at a time between individuals. They were used in Japan in the 1600s, and the tradition of individual contracts continued up until the late 19th century. In 1865, the Chicago Board of Trade (CBOT) changed the game.

The CBOT, an exchange hub for most of America’s mid-west grain farmers, began to standardise futures contracts. They graded quality of wheat, corn, and other commodities and they established a standard measure of grain. That way, one contract from farmer Jones was the same size and quality as one contract from farmer Smith. This made the contracts interchangeable. Buyers could trust quality and size, and it no longer mattered from which farm the grain came.

Standardisation of Contracts: This standardisation of contracts gradually expanded to other assets. In the late 1960s, non-agricultural commodities, including raw materials such as gold and oil, began to be traded with futures. The futures market met the needs of buyers and sellers such as oil companies selling to airlines, or miners selling to manufacturers. The seller locked in a fair price for the commodity. And the buyer could budget expenses knowing the cost they’d have to pay for the product.

But soon banks and investors saw it as a profit play. The underlying asset (corn, oil, gold) is much less important than the movement of the price. Bankers never intend to own the asset. They just want to make a profit on the risk and volatility.

If you believe the price of a commodity could go up, you simply buy the contract that guarantees it at a lower price. Then you look for it to rise and profit from the difference. This was the beginning of CFD trading as we know it today.

The Rise of the Foreign Currency Exchange Market: Another turning point in trading came with the end of the gold standard. In 1971, the Bretton Woods system collapsed. This system pegged all currencies to each other, based on the price of gold. When it failed, currencies became highly volatile, so they offered another financial instrument for trading. This opened the floodgates for the expansion of the futures markets and created many new financial instruments.

Over the years, many forms of futures were conceived on Wall Street. Then things morphed again. If you could trade on the underlying asset of commodities, why not trade other assets such as stocks or indices? These assets have no actual physical materials to exchange. But traders didn’t want the asset. They wanted to settle accounts in cash. This type of futures transaction became known as a contract for difference (CFD). It, too, and has opened a wide array of financial opportunities for investment.

Reserved for Institutions: Futures contracts and CFDs are widely used in markets around the world. Currently, 92% of the world’s 500 largest corporations use them to manage risks. Futures contracts today cover a variety of asset classes and span virtually every aspect of global trading.

While the principle of futures and CFDs are still the same, new innovation and technology are changing the landscape. Banks and corporations have been developing more elaborate investment instruments. The majority are tailor-made according to the bank or corporation’s specific needs, as securitization tools.

For decades, financial institutions had the upper-hand over individual traders by using futures CFDs. It gave them access to markets around the world. They were able to manage their risks and diversify their portfolios more easily. Even with the advent of digital banking and global finance, futures contracts stayed in the realm of financial institutions. They remained an obscure and out-of-reach tool for most investors.

Futures Come to Individual Traders: One of the biggest barriers for the individual trader of futures contracts is that the contracts work in bulk. This means a trader has to spend a substantial amount to buy a whole contract. Similarly, the price of one share in a major corporation could be in the hundreds of dollars, locking out private investors who don’t have the required capital. One of the main benefits of CFDs is that there’s no actual ownership of the asset by the end user. With CFDs you can trade commodities and other assets in fractions, rather than purchasing the entire share or futures contract. This opens opportunities for smaller individual traders.

Next, CFDs have recently expanded to virtually all asset sectors. This allows traders to choose from a wide array of securities spread across the world. CFDs aren’t limited to your country’s exchange. You can trade on assets in the Shanghai Stock Exchange as easily as you trade on the London Stock Exchange or the New York Stock Exchange. Again, it’s because you aren’t trading the actual asset, just a CFD based on the underlying asset.

Finally, CFD trading became available to individual investors via the Internet. Now people can trade various assets and have a diversified portfolio, one much broader than ever before possible.

Essentially, CFDs evolved from being just another form of contract to the most technologically advanced asset on the market. Online platforms act as a mediator by obtaining the rights to the asset, usually from a liquidity provider, and then entering into a CFD with the end client. The underlying asset never changes hands – even when it is a commodity.

Regulation: Recently governments have stepped in with increased regulations for CFDs and their trading platforms to better protect the traders. Financial Instruments Directive (MiFID) extended coverage of the European financial services to CFDs. Expect quality platforms to hold a European MiFID license (CySEC) and a British FCA license to give users the highest levels of compliance and risk management.

11.2 Asset Ownership vs. CFDs

Financial advisors may tell you that traditional trading can accomplish as much as CFDs but CFDs have some unique advantages. Let’s take a look at the traditional and CFD benefits and limitations.

Dividends: Owing stocks entitle you to dividends and special distributions. While CFDs do not confer ownership, some brokers, like iToroStocks , offer dividends on stock CFDs. The dividend is credited to your available balance based upon the amount of stokes you hold.

Going Short: Traditional ownership offers options trading as a method of shorting a stock, but not all assets have options. Some ETFs theoretically act like a ‘short.’ They are designed to go up as the portfolio of stocks they follow go down. But they are only effective on a very short term basis. And the range of assets you can short is narrower than with CFDs.

Because CFDs operate independent of the market, individual traders can perform actions that don’t exist in traditional trading. For example, they could open short positions (to profit when an asset’s value drops down) even for assets that do not offer options in traditional markets. Moreover, CFD traders can use very flexible ‘stop loss’ and ‘take profit’ orders, which automatically stop a transaction when it reaches a predetermined profit or loss point.

A good example could be the subprime mortgage crisis. When the U.S. housing market crashed in 2008, several investors foresaw the event and were able to profit from it by convincing investment firms to create a collateralised debt instrument (CDO) that could short sell the mortgage market. However, today, one could simply use a CFD platform to open a short position without the hassle of dealing with financial institutions or big banks.

Leverage: Traditional investors can use options as a method of leveraging. A very small investment allows them to control thousands of euros worth of stokes. However, they are limited to individual stocks. Typically ETFs, indices, and many smaller stocks cannot be leveraged with options trading.

Online trading platforms offer leveraged transactions with CFDs. Traders can use a small amount of money to control a wide range of assets. This includes currencies, commodities, stocks, indices, cryptocurrencies, and assets from across the globe. While this is a good opportunity to make substantially more money than the actual capital the trader has, it is also a double-edged sword. Traders can also lose all their money and more.

Diversification: Traditional investing gives people a good range of choices. They can buy individual stocks, mutual funds, exchange traded funds, and some commodities and real estate that are held in a fund. They can choose a selection of international assets and a few foreign country specific stocks. Often these foreign assets trade ‘over the counter’ (OTC). This means you have to match buyers and sellers one-by-one without brokers or traders, so fewer stokes are available to buy or sell making the market lower volume, ‘less liquid,’ and more expensive.

Because CFD platforms are not subject to one specific market, each trader can diversify their portfolio to assets from different classes and various locations, and even virtual cryptocurrencies, such as Bitcoin, Ethereum, and Litecoin. All these assets are available on one platform. There’s no need to search for OTC ticker symbols. You don’t need to deal with securities laws of foreign countries, tax liabilities, or legal statements in other languages. Transactions on these platforms are instantaneous and highly liquid.

Fees: Traditional investor fees vary. Some pay a fixed percent of the assets in their portfolio, perhaps 2-3% each year. Some pay 5-6% on each trade. Even online discount brokers charge about $10 per trade. Savvy investors may be able to pay less, especially for options trading.

CFD’s on the other hand, only charge the spread. This may be as small as a few cents per share. Because of the number of users and the frequency of trades, online platforms can more easily offer these reduced commissions. It can make trading CFDs more profitable even when trading small amounts of assets that produce minor gains.

Trading Platforms: When you go on your trading platforms, you’ll find very little difference between buying and selling actual assets or CFDs. The look and feel of the platforms are easy to use. The choice to use leverage is the clue you are trading CFDs instead of other assets.

One popular use of the social elements on investment platforms, invented by iToroStocks , is CopyTrading. CopyTrading lets those with some money, but little time or experience, invest their funds by following and copying other successful traders automatically in real time.

This practice differs from traditional asset-management, where a portfolio manager is managing other people’s money. With copy trading, the traders that are being copied are actually trading and risking their own money. When platforms ensure copied traders don’t benefit from gains or losses of their copiers, they align the interests of the copiers and traders.

The leading social trading platforms today are fully regulated. They offer full transparency and best execution practices that promise their investors will often receive a higher standard than traditional brokers. Even with this high standard, remember that all trading involves risk. Only risk capital you are prepared to lose and past performance does not guarantee future results. International economics expert, Dr. Nouriel Roubini concluded in a recent research that by 2021, 37% of investors expect to be using social investing and trading platforms.

11.3 Before You Begin Trading

All trading puts your money at risk. It also gives you the potential for profits. Before you start, here are some things that increase your likelihood of success.

Trading Platforms: Not all CFD trading platforms are the same. You want to ensure you are going with the highest quality. It is vital the platform is transparent. Some things to check for include:

• How many traders are on the platform?
• How quick and liquid is the trading?
• What legal rules are they governed by and agree to adhere to?
• How much support and help can they give new or experienced traders?
• How easy is the site to use? Is it intuitive to navigate?
• How many assets are available to trade? Can you do currency, commodities, cryptocurrencies, indices, ETFs, stocks?
• Do you have experienced traders to follow?

Educate Yourself: Since many people use CFDs with leverage, it’s essential you understand how leverage works. It can add to your wealth, or it can destroy it. You need to know how to use it based on your portfolio size and risk level. We’ll discuss this in the next section.

You also need to develop a trading strategy. Most people who use CFDs are short term traders or day traders, although CFDs can be used in buy-and-hold strategies if you use no leverage. In order to find more success in trading, you need to know how to use technical analysis. This analysis will help you find entry and exit points.

Most pros recommend practising your strategy in virtual accounts. There you can experience real-time trading without risking actual capital. You can also backtest your strategy by going into the history of your asset to see how often the strategy would have given you wins… and how often it failed and produced losses. Learn more about day trading and swing trading if you want to make frequent trades.

While you’re educating yourself, you can also follow the trading of others to learn their strategy through iToroStocks’ CopyTrading opportunities. This gives you a chance to invest while you learn.

More and more traditional industries are shifting to the digital world, and investing is no different. The technological trend which made CFD trading available to almost anyone is still ongoing and will enable its expansion to new markets and attract new traders. When trading on a reliable, regulated digital broker, traders can take advantage of its flexibility, transparency, and social tools such as copy trading.

Online trading is a great tool for a new type of investor. This is one who easily operates from their own home anywhere in the world, and harnesses the power of the crowds. iToroStocks , the world’s leading social trading network, sets a fine example of delivering the future of trading and investing today. Be sure to consider this award-winning platform. Since the launch of CopyTrading by iToroStocks in 2010, 124 million transactions have been copied, with an 80% success rate. Still, it helps to remember all trading involves risk. Only risk capital you are prepared to lose, and past performance does not guarantee future results.

11.4 Using Leverage

One of the draws for CFDs is their ability to use leverage. Leverage is often called a two-edged sword. It can magnify your profits or your losses.

What is Leverage? People use leverage in their daily lives. If you buy a house on credit, you’ve used leverage. It’s borrowing money and using a small amount of money to control a large amount of assets. With your home, you may put 20% down (£40,000) and now you have the use of £200,000 worth of the home. Homeowners thought homes would always go up in price. But when the housing bubble came, they could not find buyers at the price they wanted and the home dropped in value. They were underwater on their loans, owing more than they could sell for. This is both the advantage and the danger of leverage.

With CFD, stock, or Forex leveraging you have the same abilities. You can use a small portion of your assets to control a large amount of securities. It’s possible to have an enormous amount of leverage. Here is a chart showing the profit/loss created by a 1% change in the underlying asset, depending on the leverage used.

How Much Should I Use? Most traders recommend novices start without any leverage at all. This is the lowest risk way to trade CFDs. It makes your potential profits lower, but it also reduces your losses. This lets you practice your strategy while reducing the chance you will ‘blow up’ your account or lose all your money.

Even as you gain greater skills, many traders only use 3x leverage or perhaps 10x at most. The more the leverage, the greater the swings you will see in your portfolio. Profitable trades will swell your assets, and then a losing trade will give you a deep drawdown. The general rule of thumb is to base your leverage level on these factors:

• Skill level
• Risk tolerance
• Capital invested

Studies have shown that small accounts are more likely to lose money than large accounts.45 This may be because small accounts cannot afford the minor pullbacks that are a normal part of trading. Their stop losses are set so tightly that they are triggered by the slightest downward movement.

It may also be because small investors want to get big fast. They are attracted to the possibility of large gains from leveraging. But they forget they can get equally large losses. A string of wins can be wiped out by one loss. And a string of losses is common. Even professional traders may have three or four losses in a row. Larger accounts are better able to handle that series of losses and keep going.

Margin is the amount of money you need to contribute to control the asset. The good news is that you are in control. You get to determine the amount of risk and the amount of loss you are willing to take. Professional traders actually determine their trade based on what they are willing to lose. Since many traders want to keep their risk on each trade to 1%-3%, they keep their margins lower as well. It’s vital to preserve your capital, or else you’ll soon have no money to trade with.

How to Determine My Leverage? The leverage is considered across your whole account, not just on one trade. It’s easy to figure out. What is your total position size including cash, assets, and positions in your account? How much equity is in your account?

Suppose you have £10,000 in your account. You’ve used that to take positions in some currencies:

• 10,000 short EUR/USD
• 30,000 long CAD/USD
• 20,000 short JPY/GBP

Your total position size is £60,000 and your asset size is £10,000. The formula is:

Total position size/ Account equity =Account effective leverage

So your leverage would be: £60,000 divided by £10,000 = 6 or a leverage of 6x

When you want to place a new trade, you may wonder what size trade to take. When you know the amount of leverage you want to use and the equity in your account, it makes it easy. Remember you want to take into account the TOTAL leverage of all your positions. If some have lost value since you put them on, you need to recalculate the effective leverage on that trade.

To find your trade size, multiply the unleveraged equity in the account by your chosen leverage. That will tell you what size position you can take on your trade. The formula would look like:

Unleveraged equity x Leverage size = Maximum trade size

So if you have €1,000 and you choose 3x leverage, your maximum trade size would be €3,000.

Leverage and Risk: Because so many new traders don’t fully factor in the risks of leverage, let’s take an example of how leverage can affect your portfolio.

It’s just as easy to have a series of losing trades as it is to have winning trades. Say you start trading with $5,000.

• First trade: 25,000 EUR/USD and it drops 2% – $500. Your 5x leveraged loss: $2,500. You now have $2,500.
• Second trade: 25,000 EUR/JPY and it drops 1%. And your trade loss is $250. But you have a smaller amount of assets in your account. So now your leverage is 10x. And so your loss is -$2,250 and you’ve just lost 100% of your equity.46

Most trading platforms help you control your risk. Platforms trading CFDs will stop your trades when your account falls to zero. Provided there is no slippage, you should not fall into a negative balance.

Stock accounts have margin limits. An investor might be able to borrow money from the brokerage firm for leverage, but the brokerage determines that equity backing the loan can’t fall below 25%.

Say you start with 2x leverage: you buy $10,000 of XYZ stock with your $5,000 in equity. Over the next week, XYZ drops in value to $6,000. Now the broker’s $5,000 loan is only backed by $1,000 of equity. That’s only a 20% margin. When the equity backing the loan falls below 25%, the broker can issue a margin call. That means you either need to add money to your account or sell stock in order to get your account margin back up.

If you don’t do that promptly, the broker will sell stock to cover the margin call without letting you know. This can lock in further losses. When you buy the stock, as opposed to a CFD, only the margin on the leveraged stock is taken into account in determining the margin.

Slippage: Your stop loss setting or brokerage order doesn’t guarantee the asset will be sold at that price. The difference between the desired sell price and the actual price at which your trade is executed is called slippage. In a fast moving market, this amount may be considerable. Flash crashes are notorious for triggering sell orders that execute far below the stop loss price.

Suppose you enter a Bitcoin trade at $2600. You place a protective stop loss at $2500. A sudden new event drops Bitcoin price to $2200 in a matter of minutes. The platform enters your selling trade the moment the price moves to $2500. But there are no buyers there. The buyers have already lowered their price. The sale may be made at $2300 or even lower. If you use limit orders, the trade will not execute until that price or better. But then you risk not selling at all and taking steeper losses.

Comparing Leverage: Understanding the risks of leverage will help you make better decisions as you use it. Here is a chart showing the power of leverage by comparing two traders using different leverage. Call them William and Ben. Ben’s loss allows him to move on to new trades. William’s loss seriously impacted his portfolio.

You can better manage your risks by:

• Using low levels of leverage
• Using trailing stops to protect your capital
• Practising your trading strategy until it works in all situations
• Setting up the trade according to the amount you are willing to lose
• Limiting your capital to 1% or 2% per trade on each position
• Stop trading for the day if your emotions are getting in the way

Novice traders get excited about the leverage possibilities with CFDs, but only when they are winning. If they use leverage unwisely, they may drop out of investing before they learn enough. So get educated. Start with no leverage. Get your strategy to the point that the winning trades outnumber the losing ones. Make sure the amount of money from the wins is much greater than the loss in losing trades and then leverage can help you work toward larger gains. Always be sure you are trading within your means.