Definition and core idea
– A contract for difference (CFD) is a private derivative contract between a trader and a broker that settles in cash for the change in price of an underlying instrument. No physical asset or exchange-listed security changes hands; the parties simply net the difference between the opening and closing prices.
– CFDs let you take a position that profits if the underlying price rises (a long position) or if it falls (a short position).
Key features (brief)
– Cash-settled: gains or losses are paid in cash through the broker account.
– Over‑the‑counter (OTC): CFDs are arranged through broker networks, not traded on major public exchanges.
– No expiry: unlike many futures, most CFDs do not have a preset expiration date.
– Leverage and margin: brokers typically require only a fraction of the full exposure as collateral, amplifying both gains and losses.
– Corporate actions: CFDs usually mirror dividends and other corporate events (adjusted in cash).
– Cost model: brokers generally make money from the bid‑ask spread and, in some cases, financing/overnight fees rather than commissions on every trade.
– Availability: CFDs are widely offered in many jurisdictions but are not available to retail clients in the United States.
Plain definitions of common terms
– Leverage: using borrowed funds from the broker to increase the position size relative to capital posted. Higher leverage increases both potential return and potential loss.
– Margin: the initial collateral required by the broker to open and maintain a leveraged position—often expressed as a percentage of the notional exposure.
– Spread: the difference between the broker’s quoted buy (ask) and sell (bid) prices; the spread is effectively a transaction cost.
– OTC (over‑the‑counter): trading conducted directly through broker platforms rather than via an organised exchange.
Pros and cons (concise)
Pros
– Low capital outlay: margin requirements let traders control larger exposures with less cash.
– Long and short flexibility: positions can be taken on rising or falling prices without borrowing the underlying asset.
– Wide market access: many brokers provide CFD exposure to stocks, indices, ETFs, commodities and futures prices from multiple markets.
– Corporate-action adjustments: CFDs generally pass through dividend payments and other corporate adjustments in cash form.
Cons / Risks
– Leverage risk: small price moves can produce large gains or large losses relative to capital posted.
– Counterparty risk: CFDs are broker contracts; the trader depends on the broker’s solvency and integrity because the market is less regulated in many places.
– Wide spreads and volatility: during volatile times spreads can widen, increasing costs and hurting small-move strategies.
– Margin calls and forced closeouts: losses can require additional deposits; brokers may liquidate positions to protect themselves.
– Limited availability: retail CFD trading is prohibited in some jurisdictions (notably the U.S. for many retail products).
Short checklist before trading CFDs
1. Confirm regulatory status: is the broker licensed by a reputable regulator (e.g., FCA, ASIC, ESMA supervision)?
2. Understand margin rates: what initial and maintenance margin will the broker require?
3. Check costs: typical spreads, overnight/financing fees, and any additional charges.
4. Test execution: use a demo account to check price quotes, execution speed and slippage.
5. Know corporate action treatment: how dividends and splits are handled in your CFD terms.
6. Set risk limits: plan position size, stop losses, and maximum acceptable leverage.
7. Review counterparty protection: what protections (segregated accounts, compensation schemes) exist if the broker fails?
Worked numeric example (illustrative)
Assumptions:
– Underlying stock current price: $100.
– Trader opens exposure to 100 CFDs (not owning the shares) → notional exposure = 100 × $100 = $10,000.
– Broker margin requirement: 10% initial margin.
– Broker spread ignored for simplicity; financing and fees omitted.
Calculations:
– Required initial deposit = 10% × $10,000 = $1,000.
– If stock rises 5% to $105: profit = 5% × $
= Worked numeric example (continued) =
– If stock rises 5% to $105: profit = 5% × $10,000 = $500.
– Return on initial margin = $500 / $1,000 = 50%.
– If stock falls 10% to $90: loss = 10% × $10,000 = $1,000.
– That equals the initial deposit, so equity is zero and the position would be closed or the trader would owe the broker (depending on the broker’s negative-balance policy).
– Leverage and exposure summary:
– Notional exposure = $10,000.
– Initial margin = $1,000 → effective leverage = 10:1 (notional / margin).
= Margin-call and liquidation example (numeric) =
Assumptions (additional): maintenance margin requirement = 5% of notional = $500. Maintenance margin is the minimum equity the broker requires to keep the position open.
Let P be the share price at which equity equals the maintenance margin.
– Equity = initial margin + unrealized P/L = $1,000 + (P − $100) × 100 shares = 100P − $9,000.
– Solve 100P − $9,000 = $500 → 100P = $9,500 → P = $95.
Interpretation: if the share price falls to $95, equity has fallen to the maintenance margin ($500). The broker will typically issue a margin call or start liquidating to avoid further losses. A fall below $95 would leave insufficient equity and likely trigger forced close-out.
= Financing (overnight funding) example =
CFDs are leveraged: the broker finances the notional exposure. Financing is usually charged (or credited) daily for positions held overnight.
Simple daily financing formula:
Financing charge = Notional × annual interest rate × days/365.
Example: notional $10,000, annual financing rate 3% for long positions:
– Daily financing ≈ $10,000 × 0.03 × 1/365 ≈ $0.82 per day.
– Held 30 days → financing ≈ $0.82 × 30 ≈ $24.6.
Note: brokers may add a spread or use different rate bases (e.g., LIBOR/EURIBOR + markup). Short positions can have different financing (and may be charged for dividends).
= Corporate actions and dividends (practical points) =
– Dividends: CFD providers typically adjust positions for cash dividends. If you’re long, you generally receive a dividend adjustment (credited). If you’re short, you usually pay the dividend adjustment (debited). Adjustments may be grossed-up or net of withholding tax depending on broker and jurisdiction.
– Splits/consolidations: contracts are adjusted for share splits to keep notional exposure equivalent (either contract size or price changes).
– Other corporate events: rights issues, spin-offs, delistings may be handled case-by-case — check broker terms before trading.
= Short checklist before opening a CFD position =
1. Confirm instrument specs: contract size, minimum trade size, trading hours.
2. Verify margin terms: initial and maintenance margin percentages.
3. Model scenarios: calculate profit/loss at realistic price moves and the liquidation price.
4. Include costs: spreads, commissions, slippage, daily financing, and dividend adjustments.
5. Size position to risk: limit potential loss to an acceptable % of your capital.
6. Set orders: entry, stop-loss, and take-profit as appropriate.
7. Know broker protections: negative-balance policy, account segregation, and compensation schemes.
8. Practice on a demo account if available.
= Practical example with stop-loss =
Using the original assumptions, trader sets a stop-loss at $95:
– If the stop executes at $95: loss = ($100 − $95
: loss = ($100 − $95
) = $5 per share.
If the trader holds 100 shares (or 100 CFD units) the realized loss when the stop executes is:
– Loss per unit = $100 − $95 = $5
– Total loss = $5 × 100 = $500
Worked leveraged CFD example (clear assumptions)
Assumptions:
– Entry price = $100
– Stop-loss = $95
– Position size = 1,000 CFD units (exposure = $100,000)
– Provider initial margin = 10% (required cash = $10,000)
– Financing rate (overnight) = 4% per annum, charged on notional exposure
– No commissions for simplicity; include spread later
Step 1 — P/L if stop is hit
– Per-unit loss = $5
– Total loss = $5 × 1,000 = $5,000
– Loss as % of posted margin = $5,000 / $10,000 = 50% of initial margin
Step 2 — Effect of financing (one day)
– Daily financing ≈ (4% / 365) × $100,000 ≈ 0.0001096 × $100,000 ≈ $10.96
– If position is held 7 days before stop executes, financing ≈ $10.96 × 7 ≈ $76.72
– Add financing to trading costs when assessing risk
Step 3 — Include spread and slippage
– If spread at entry is $0.10 and on exit (stop) execution is $0.15 worse due to slippage, the additional cost per unit ≈ $0.25
– Spread/slippage cost = $0.25 × 1,000 = $250
– Net total loss in this scenario = $5,000 (P/L) + $76.72 (financing) + $250 (spread/slippage) ≈ $5,326.72
Step 4 — Margin call / liquidation price (simple linear example)
– Let M0 = initial margin posted ($10,000)
– Maintenance margin requirement = say 50% of initial margin → Mmaint = $5,000
– Equity = initial margin − unrealized loss
– Liquidation occurs roughly when Equity ≤ Mmaint
Solve for price Pliq where unrealized loss = initial margin − Mmaint
– Unrealized loss at liquidation threshold = $10,000 − $5,000 = $5,000
– Per-unit loss at liquidation = $5,000 / 1,000 = $5 → Pliq = $100 − $5 = $95
Note: This simplified liquidation calculation assumes no buffer, immediate execution, and the broker liquidates at the same price; in practice brokers add buffers and use maintenance margin percentages, so actual liquidation price may differ. Always confirm formulas with your broker’s specs.
Quick checklist before placing a CFD trade
– Confirm contract size and whether quoted price is per share or per contract.
– Calculate required initial margin and how many units you can hold.
– Compute per-unit P/L scenarios for realistic adverse moves.
– Estimate daily financing costs and include likely spread/slippage.
– Choose stop-loss and calculate worst-case cash loss including costs.
– Verify broker’s margin call and liquidation policy (how and when they close positions).
– Use position-sizing so the potential loss (including costs) fits your risk tolerance.
– Practice on a demo account to validate calculations and execution behavior.
Common pitfalls and how to avoid them
– Ignoring financing: for multi-day trades, financing can turn a small edge into a loss — include it in breakeven calculations.
– Misreading contract units: confuse “per share” quotes with “per contract” multipliers; always convert to notional exposure.
– Overleverage: small adverse moves can wipe posted margin; limit leverage and size relative to capital.
– Assuming stops guarantee execution
— Assuming stops guarantee execution: stop orders are instructions to your broker but do not eliminate gap risk. A stop-loss becomes a market order at the trigger and can be filled worse than the stop price in fast markets or across news gaps. If your broker offers a guaranteed stop (a stop that executes at the nominated price) it usually costs extra; otherwise plan for slippage when sizing trades.
Other common pitfalls and how to avoid them
– Overlooking counterparty risk: CFDs are typically over-the-counter (OTC) contracts with your broker as the counterparty. Check the broker’s credit, segregation of client funds, and whether there is negative-balance protection. If the broker fails, your claims may be slower or limited.
– Liquidity misconceptions: Not all CFDs are equally liquid. Low-liquidity underlying assets can have wide spreads and sporadic fills. Verify average spread, market hours, and the broker’s liquidity providers.
– Corporate actions and dividend adjustments: CFD exposures are adjusted (credits/debits) for dividends, stock splits, and rights issues but not always in a straightforward way. Read the broker’s policy and model the cash-flow effect for long and short positions.
– Tax and reporting differences: CFD gains/losses and dividend adjustments may be taxed differently than direct equity ownership in your jurisdiction. Consult a tax professional for specifics.
– Ignoring regulatory limits and suitability constraints: Many regulators impose leverage caps, marketing rules, or suitability checks that affect retail CFD trading. Know the rules that apply to you.
Practical checklists (pre-trade and position management)
Pre-trade checklist
1. Define trade objective and horizon (scalp, swing, hedge).
2. Determine notional exposure: Notional = Price_per_unit × Units.
3. Calculate required initial margin: Initial_margin = Notional × Initial_margin_rate.
4. Set stop-loss in price terms and compute cash risk per unit: Risk_per_unit = Entry_price − Stop_price (for long).
5. Compute position size: Units = (Account_equity × Risk_fraction) / Risk_per_unit.
6. Include round-trip costs: Spread + commissions + expected financing.
7. Confirm sufficient free margin and emergency buffer (e.g., at least 20–50% of account equity).
8. Verify broker margin call / liquidation policy and guaranteed stop availability.
Position-management checklist
1. Record entry price, stop, target, notional, margin used, and break-even price after costs.
2. Monitor intra-day margin utilization and P/L.
3. Adjust stops only with a documented plan (trail, time-based, event-based).
4. Close or hedge ahead of major news if you cannot accept gap risk.
5. Recalculate financing if trade extends beyond initial hold period.
Key formulas (plain language)
– Notional exposure = Price_per_unit × Units.
– Required initial margin = Notional × Initial_margin_rate.
– Position size (units) = (Account_equity × Risk_fraction) / Risk_per_unit.
Example: Account equity = $10,000; Risk_fraction = 1% (so $100); Entry = $50; Stop = $48 → Risk_per_unit = $2 → Units = $100 / $2 = 50 shares.
– Financing cost per day = Notional × (Annual_financing_rate / 365).
If the broker charges base rate + markup, use that full annual rate.
Worked numeric example (long CFD trade, multi-day)
Assumptions:
– Entry price = $50.00 per share.
– Spread (ask – bid) = $0.06 per share (you pay this on entry/exit).
– Units = 1,000 shares → Notional = $50,000.
– Initial margin requirement = 10% → Required margin = $5,000.
– Stop-loss = $48.00 → Risk_per_unit = $2 → Total risk = $2 × 1,000 = $2,000.
– Account equity = $10,000 → risk fraction = 10% → OK (risk $1,000) — but note computed position above risks $2,000, so you’d need to reduce size.
– Broker financing (long) = 3.5% annual.
Step calculations:
1. Spread cost round-trip = $0.06 × 1,000 × 2 = $120 (you lose the spread
on entry and exit).)
2. Initial margin posted = 10% × $50,000 = $5,000. This is the cash (or buying power) the broker holds as collateral.
3. Effective leverage = Notional / Account equity = $50,000 / $10,000 = 5×. (You are using 5× exposure; the margin requirement implies up to 10× possible exposure if you used all equity.)
4. Price move to stop-loss (unfavourable scenario):
– Price loss = (Entry $50.00 − Stop $48.00) × 1,000 = $2.00 × 1,000 = $2,000.
– Add round‑trip spread = $120 (from step 1).
– Financing cost (long): use formula Financing = Notional × Annual rate × Days / 365.
Example for 14 days: 50,000 × 0.035 × 14/365 ≈ $67.13.
– Total loss