A Contract for Difference (CFD) is a binding agreement between two parties (typically a trader and a broker) to exchange the difference in price of a financial product between the time the contract opens and closes. It is thus the difference in price between the opening and closing of the contract that is exchanged.
One of the advantages of using CFD:s is that there is no need to actually buy and sell assets such as company shares or commodities to profit from price movements. You can gain exposure to price movements without ever having to own the underlying asset. This saves on transaction costs, stamp duty and similar.
The fact that you do not own the underlying asset is one of the defining characteristics of a CFD. A share CFD can rise and fall with the price of a company share, but the trader does not normally become a shareholder in the company. The position is instead a contract with the CFD provider based on changes in the referenced market price.
This makes CFDs useful for traders who are mainly interested in short-term price changes rather than long-term ownership. A trader can gain exposure to a stock index, currency pair, commodity or individual share without having to arrange ownership and delivery of the underlying asset. The exact markets available depend on the broker.
A CFD can also be closed without selling an actual asset to another investor. The trader simply closes the contract with the provider. The resulting profit or loss is calculated from the difference between the opening and closing values, adjusted for the position size and applicable trading costs.
You do not own the underlying asset
CFD trading provides economic exposure rather than ownership. This distinction becomes particularly important when CFDs are based on company shares. Someone who buys ordinary shares becomes a shareholder, while someone who opens a CFD based on those shares holds a derivative contract.
A CFD trader will not normally receive shareholder voting rights because the trader does not own the shares. Dividend events can still affect CFD positions, and brokers may make cash adjustments depending on whether a trader holds a long or short position, but this is not the same as receiving an ordinary dividend as a shareholder.
Ownership also matters for long-term costs. A fully paid share can normally be held without paying a daily leveraged financing charge simply because the investor continues to own it. A leveraged CFD position can incur financing for as long as it remains open, making the economics different for positions held over long periods.
Using a CFD also means that you do not need to have enough money to actually buy the asset. One share in the company NVR Inc. currently costs more than 4,850 USD. If you want to buy 100 shares, it will require an investment exceeding 485,000 USD. With a CFD based on the price movement of this share, you do not have to worry about the big price tag – your only focus will be movements.
The amount of money required to open the CFD is normally determined by the broker’s margin requirement. If only a fraction of the total position value is required as margin, the trader can obtain exposure to a position that is worth considerably more than the cash deposited to support it.
This should not be interpreted as making expensive shares inexpensive in terms of risk. If a CFD gives you exposure equivalent to 100 shares, profit and loss will generally reflect the movement of those 100 shares even if you deposited only a fraction of their full market value as margin.
How leverage changes the trade
Leverage allows a trader to control a position with a larger market value than the amount deposited as margin. This is one reason CFDs became popular with traders who do not want to commit the entire notional value of every position.
Assume that a CFD position has a market value of €20,000 but the broker requires only €2,000 in margin. If the underlying market moves by 2%, the value of the position changes by approximately €400 before costs. The underlying asset moved only 2%, but the €400 change is equal to 20% of the €2,000 used as margin.
The same calculation applies to losses. A 2% adverse market movement can reduce the original margin by roughly 20% in this example. Larger leverage ratios increase this effect because a smaller amount of cash supports the same amount of underlying market exposure.
Margin is therefore not the same thing as risk. A broker might require only €500 to open a certain position, but that does not mean €500 is necessarily the amount you can lose on the trade. The trader needs to know the full position value and how much that position will change for each movement in the underlying market.
You can profit from falling prices too
With traditional trading, the basic principle has always been to buy now and sell when the price is higher. This makes it difficult to profit in falling markets. Yes, short-selling is an option, but comes with its own sets of risks that can be off-putting for the average small-scale retail trader.
With CFD:s, it is very easy to speculate on both rising and falling prices. CFD:s are divided into two main categories: upward or downward. If you think the price is going up, you get an upward CFD, and vice versa.
A long CFD position gains value when the underlying market moves in the trader’s favour by rising. A short CFD position is used when the trader expects the market to fall. This makes changing direction relatively simple because the trader normally uses the same account and platform for both types of position.
For example, assume that a share is trading at €50. A trader expecting the price to rise can open a long CFD. If it reaches €55, the trader has gained €5 per unit of exposure before costs. Another trader expecting the price to fall can open a short CFD instead. If the share falls from €50 to €45, that €5 movement works in favour of the short position.
Being able to profit from declining markets does not reduce risk. A short CFD will lose money when the underlying price rises, and some markets can move upward very quickly. Long and short positions therefore both require a clear exit plan and appropriate position size.
CFDs can track many different markets
CFDs are not restricted to individual company shares. Brokers commonly offer contracts based on stock indices, currencies, commodities and other financial markets. This allows traders to access several types of price movement through one trading account.
An index CFD can provide exposure to the movement of a broad stock-market benchmark without requiring the trader to buy every company represented by the index. Commodity CFDs can provide exposure to markets such as gold or oil without taking physical delivery, while forex CFDs allow traders to speculate on changes between two currencies.
Different underlying markets behave differently. A strategy developed for a heavily traded currency pair might not perform in the same way when applied to an individual small-company share or a volatile commodity. Having access to many markets is useful, but access and knowledge are not the same thing.
Costs
The costs will vary, so it is important to check the terms and conditions of your specific broker.
Generally speaking, CFD brokers will charge a commission and/or make money from the spread. If you use leverage, there will also be a financing cost to take into account.
The complete cost of CFD trading can therefore be higher than the single fee displayed most prominently by a broker. A platform advertising commission-free trading can still earn money through the spread and financing. A broker advertising very narrow spreads can charge a separate commission instead.
Trading frequency and holding period determine which costs matter most. A day trader making many transactions can be highly sensitive to spreads and commissions. A trader holding one leveraged position for several weeks may care much more about the financing charged each night.
The spread
The spread is the difference between the broker’s buy price and sell price. It is an important cost because a newly opened position will normally begin slightly below its break-even point. The market first needs to move far enough in the trader’s favour to overcome the spread.
Spreads can vary between instruments and brokers. They can also change according to market conditions. Highly liquid markets usually have narrower spreads than less actively traded assets, while spreads can widen during volatile periods or when liquidity is poor.
This is particularly important for short-term trading. If a strategy attempts to capture a movement of only a few points, even a modest spread can consume a substantial part of the potential return. A trader targeting a much larger market movement is less sensitive to the same spread.
Commission
The commission can be fixed (e.g. €0.03 per underlying share) or a percentage of the trade (e.g. 0.10%).
Please remember that the opening and the closing are considered two separate trades.
Today, there are quite a few brokers available that will not charge any commission on CFD:s when the underlying is forex or a commodity.
This does not necessarily mean that the transaction is free. A broker that charges no separate commission can include its compensation in the spread. Traders should therefore compare the total cost of completing a round trip rather than comparing commission figures by themselves.
Commission becomes particularly important for active traders. A small fee applied to one trade might look insignificant, but the same charge applied hundreds of times during a month can materially reduce the strategy’s final result.
Financing
Using leverage typically come with a fee, the cost can go up considerably if you keep a leveraged position open over night. It is therefore very common for CFD traders who use leverage to close all open positions before the trading day is over.
Financing is commonly calculated using the full value of the leveraged position rather than only the margin deposited. This can make the financing burden larger than new traders expect. A trader might have only €2,000 tied up as margin but pay financing based on exposure worth €20,000.
Modern brokers can use different reference rates and financing formulas. LIBOR was historically widely used as a benchmark, including in older CFD examples, but it has largely been replaced by newer benchmark rates. Traders should therefore check the current financing formula used by their broker rather than assuming an older reference rate still applies.
The impact depends heavily on the holding period. A trader opening and closing the position during the same day might avoid most overnight financing. A trader keeping a leveraged CFD open for several weeks can accumulate a meaningful cost even when the market moves in the expected direction.
Example
The broker is offering CFD:s based on the share price of Company ABC.
The trader places a trade when the current share price for Company ABC is €23.50. The trader expects the share price to rise to €24.80. The bid-offer spread is 24.80-23.50.
The trader buys 426 contracts at €23.50 per share, so the trading position is €10,011.
The broker charges a 0.1% commission on the opening of this position. When the position is closed, the broker will charge another 0.1% commission.
If the trader keeps the position open over night, the trader will be charge an over-night financing fee. With this broker, that fee is LIBOR interest rate + 2.5 percentage points. (LIBOR is the benchmark interest rate at which major global banks lend to one another.)
In this example, it takes 16 days for the share price to reach €24.80.
Initial value of the trade: €10,011
Final value of the trade: €10,564.80
Profit before costs:
€10,564.80 minus €10,011 = €553.80
- Commission when opening the position: €10
- If we assume that LIBOR + 2.5 percentage points is 7.5% interest, then the daily cost for interest will be 426 contracts x €23.50 x (0.075/365) = €2.06.
€2.06 x 16 days = €32.89
- Commission when closing the position: €10
€553.80 (profit) minus €20 in commissions and €32.89 in interest costs = €500.91 net profit.
The example illustrates why looking only at the movement of the underlying share can overstate the result of a CFD trade. The price movement produced a gross profit of €553.80, but commission and financing reduced the amount retained by the trader.
If the position had remained open for longer, financing costs would have continued to accumulate. If the market had taken several months rather than 16 days to reach the target, the difference between gross and net profit could have been considerably larger.
The same principle applies when a trade loses money. Trading costs are still present, which means the final loss can be somewhat larger than the loss caused by the underlying price movement alone.
Slippage
Another potential cost is slippage. This happens when an order is executed at a different price from the one the trader expected. If a market is moving quickly, the quote can change between the moment the order is submitted and the moment it is filled.
Slippage can occur during major economic announcements, company earnings releases or sudden periods of market stress. It can also occur in markets with relatively poor liquidity. The difference might be very small on one transaction but can matter to traders making many short-term trades.
Slippage is not automatically evidence that a broker has done something wrong. Prices genuinely change during fast markets. Traders should nevertheless pay attention to actual execution because advertised spreads only describe part of the trading cost.
Stop-loss orders
A stop-loss order instructs the broker to close a CFD position when the underlying market reaches a chosen level. Stops are commonly used to prevent one losing trade from continuing indefinitely.
An ordinary stop does not necessarily guarantee the exact exit price. If the market gaps through the stop level, the position can be closed at the next price available. This can make the realised loss larger than planned.
Some CFD providers offer guaranteed stop-loss orders on certain markets. These can provide more certainty about the maximum exit level but usually come with an additional charge or other conditions.
A stop should also be combined with sensible position sizing. Placing a stop far away from the entry while using an enormous position can still create an unacceptable financial loss. The amount at risk should be calculated before opening the trade.
Margin calls and forced liquidation
A broker needs sufficient margin in the account to support leveraged CFD positions. If losses cause account equity to fall too far, the trader can face a margin call or the broker can begin closing positions according to the applicable account rules.
Allowing a position to reach forced liquidation is normally a poor substitute for planned risk management. By that stage, a substantial part of the account can already have been lost. Traders usually benefit from deciding where a trade is wrong before the broker’s margin system has to make that decision for them.
Several open positions can also create combined margin pressure. A trader might have enough capital to support each position separately but experience problems if several related markets move adversely at the same time.
CFDs for day trading
CFDs are commonly used by day traders because positions can be opened and closed quickly, long and short exposure is straightforward, and several asset classes can be accessed from one account.
Closing positions before the end of the trading session can also reduce exposure to overnight financing and market gaps. The trade-off is that frequent traders pay spreads or commissions repeatedly, so execution costs become particularly important.
A day trader targeting a very small market movement might find that a large portion of the potential profit disappears into the spread. The same transaction cost is less important to a position targeting a much larger move.
Day trading also requires discipline because a CFD platform makes new trades very easy to place. The fact that hundreds of markets are available does not mean that there is a good opportunity in hundreds of markets.
CFDs for longer-term trades
It is possible to keep CFD positions open for days, weeks or longer, but financing becomes more important as the holding period increases. A strategy that looks inexpensive for one day can become costly after several weeks of daily charges.
Longer holding periods also expose the trader to more overnight events. A stock can gap after company news, an index can react to political developments and currencies can move after unexpected economic announcements.
For very long-term exposure, purchasing the underlying asset can sometimes make more economic sense because the investor avoids repeated leveraged financing charges. The appropriate choice depends on the market, position size and purpose of the trade.
CFDs compared with conventional investing
Traditional investing and CFD trading can both provide exposure to changes in financial markets, but they are designed for different purposes. Conventional investors normally purchase assets and benefit from ownership. CFD traders normally speculate on price movements through a contract.
Buying shares can require more capital upfront, but it also avoids some of the financing costs associated with leveraged CFDs. The investor can potentially receive voting rights and dividends and can hold the shares without an expiry date.
CFDs provide easier leverage and short exposure, which can be useful to active traders. They can also make it easier to gain temporary exposure to an index or commodity without purchasing a corresponding asset directly.
Neither method is inherently better in every situation. A short-term trader and a long-term investor can reasonably choose different instruments even when they have a similar opinion about the same market.
Counterparty risk
A CFD is a contract with a provider, which means traders face more than market risk. The financial and regulatory status of the broker also matters because the position exists through that company.
Traders should understand which legal company holds the account, which regulator applies and how client funds are handled. International broker brands can operate through several separate companies, and the protections attached to one company do not automatically apply to another.
The quality of the trading platform alone does not answer these questions. A professional-looking website and fast mobile app can be supplied by both reputable and unsuitable brokers. Legal identity and account terms matter more.
Not in the United States
Contracts for Difference are not permitted in the United States. For more information, contact the United States Securities and Exchange Commission (SEC).
This means that the retail CFD market found in countries such as the United Kingdom and parts of Europe does not operate in the same form for US retail traders. US traders instead have access to other regulated instruments for obtaining leveraged or short market exposure.
Financial rules differ between jurisdictions, so the fact that a broker offers CFDs internationally does not mean that every visitor to its website can legally open the same type of account. Product availability, leverage and client protections can change according to the trader’s country and the legal entity providing the service.
Who should consider CFD trading?
CFDs are primarily designed for active market participants who understand leverage, margin and the costs associated with maintaining a position. They can be useful for day trading, short-term speculation, hedging and gaining temporary exposure to markets that would otherwise be awkward or expensive to trade directly.
They are generally less appropriate for someone whose objective is simply to purchase assets and hold them for many years. The financing and counterparty structure of a CFD can make conventional ownership more suitable for that type of investor.
Beginners should pay particular attention to position size. The small amount of margin required to open a trade can make the position look less risky than it actually is. The market exposure should always be considered in full.
A CFD makes it easy to express an opinion about whether a market will rise or fall. It does not make that opinion more likely to be correct. The trader still needs a sensible method, realistic costs and a plan for controlling losses when the market disagrees.