CFD trading – an introduction
CFDs are highly speculative financial derivatives, which are only suitable for investors who are aware of the special risks of this asset class in addition to the opportunities. How CFD trading works and what investors should be aware of when trading CFDs and choosing a CFD broker.
CFD – CONTRACTS FOR DIFFERENCE
Bereits in den 1990er Jahren kamen CFDs unter institutionellen Händlern zum Einsatz. Die Abkürzung CFD steht für Contracts for Difference und meint Differenzgeschäfte; Investmentbanker sprechen auch von Equity Swaps. Im Interbankenmarkt, also dem Handel zwischen Kreditinstituten, werden diese Kontrakte vor allem zu Absicherungszwecken eingesetzt. Mit der Einführung der Stempelsteuer (Stamp Duty Reserve Tax) in England im Jahr 1986 wurden CFDs auch unter spekulativen Anlegern immer beliebter. Denn die beim Verkauf von Aktien fällige Steuer in Höhe von 0,5% auf den Geldwert ließ sich damit geschickt umgehen.
CFD trading takes place mostly off-exchange
In contrast to shares, CFD trading takes place mainly over-the-counter (OTC) – i.e. outside the organized or regulated market. In over-the-counter trading, purchases and sales are settled directly with the CFD broker/market maker. This broker/ market maker sets the buying and selling prices, determines the conditions and offers trading opportunities. When choosing a suitable broker, CFD traders should therefore check which market maker will settle the CFD trade.
CFD trading is interesting for investors who are willing to take risks because CFDs allow them to invest in underlying assets that a “normal investor” cannot trade. For example, with CFD trading, only one DAX contract can be purchased. Trading CFDs on interest or DAX futures, commodities such as coffee, oil or sugar is also exciting. Speculation on special indices is also possible, for example trading a volatility index. The market maker is responsible for the corresponding liquidity in the market, sets buying and selling prices and thus ensures the tradability of the CFDs.
What is a CFD?
CFDs belong to the category of derivatives, so the price of a CFD is derived directly from the respective underlying asset, for example a share or an index. Investors therefore do not acquire an interest in a company or any other real asset and therefore have no rights to participate in a general meeting or to deliver the underlying asset, for example. Instead, CFD traders are holders of a claim against the CFD contract partner or the CFD broker. What many people do not know, however: When it comes to dividends, CFD traders are virtually equal to shareholders. CFD traders who bet on rising prices are credited 85% of the dividend on the ex-dividend day (exD), i.e. the day on which the dividend is paid out. However, investors who hold a short CFD on this day must pay the full dividend.
How does CFd trading work?
CFD trading allows investors to participate in price movements of indices, stocks, currencies or commodities with leverage. As the name suggests, a contract for difference is a contract to trade the difference between the time of entry and exit, the so-called spread. Investors can trade CFDs that profit from rising prices (long CFDs) and those that profit from falling prices of the underlying asset (short CFDs).
The most significant difference between CFDs and classic securities such as shares or funds is that CFD trading requires only a small capital investment, but CFDs still move 1:1 to the underlying asset. In short: All factors influencing the price of the underlying asset have a full impact on the contract for difference in CFD trading.
Important: With CFD trading, investors can thus trade the full price movements of shares, indices, commodities, bonds, etc. with a fraction of the capital otherwise required.
CFD Trading: What investors should look for when trading with leverage
Unlike stock trading, CFD trading requires investors to pay only a fraction of the investment amount for their trading position. CFD traders only deposit a security deposit, or margin. The margin depends on the selected underlying asset.
The investment costs for CFD trading are thus significantly lower than those that would be payable for a direct investment in the underlying instrument. These costs are usually only one to ten percent of the traded amount. With CFD trading, investors trade the underlying asset virtually on credit.
As a rule, buyers must therefore pay financing interest. By contrast, investors who go short with CFDs usually receive credit interest. The reason: They initially act as the seller of a CFD. The short traders must then buy back the “short” CFD when the position is closed out.
However, the decisive role in CFD trading is played by leverage. With contracts for difference, investors leverage their investment many times over.
An example: When trading ten DDAX contracts, the CFD trader deposits a margin of one hundredth or one percent. With a DAX index level of 1,000 points, the margin is thus 1,000 euros (10 x 1,000 x 1/100). In other words: With an investment of 1,000 euros, investors move 100,000 euros on the stock exchange (10 x 1,000) with CFD trading. If the DAX then increases by 100 points to 10,100 index points, the CFD contract reacts exactly like the index, thus gaining 100 euros in value. What for an ETF or certificate investor is only a change of one percent, for the CFD trader investing with leverage it is equivalent to a change of one hundred percent, as the value of his ten DAX CFDs doubles by 1,000 euros (10 x 100 dollars) to 2,000 euros.
|Price change of 1%||10€||100€||1.000€|
|Price change of 5%||50€||500€||5.000€|
Attention: Also and especially when trading CFDs, investors should be aware that every opportunity is accompanied by a corresponding risk. If the DAX falls by 50 points (-0.5%), the CFD contract mentioned in the above example loses a massive amount of value (-50.0%). As you can easily see: CFD trading is associated with not inconsiderable risks. Until May 2017, investors could even lose more than just their deposit (obligation to make additional contributions). In Germany, thanks to a “general ruling” of the BaFin (Federal Financial Supervisory Authority) of 08.05.2017, private customers may no longer be offered contracts with an obligation to make additional contributions.
An example from the year 2015 shows how strongly CFDs can react to price changes: In January 2015, the Swiss central bank announced that it was lifting the peg of the Swiss franc to the euro. On that day, the EUR/CHF currency pair recorded sharp price swings, and at one point the associated currency pairs were no longer tradable at all. In the end, the decision by the central bank caused the Swiss franc to appreciate by around 20% against the euro. Investors in CFD contracts that had been leveraged up to this point saw exceptionally high gains or exorbitant losses, depending on their positioning.
Stronger regulation in CFD and Forex trading
The European Securities and Markets Authority (ESMA) has enforced stronger regulation of CFD and Forex trading as of 1 August 2018. Not only the CFD providers are affected by this, but the new regulations will also affect your trading in CFDs and Forex.
As a result of the ESMA’s decision, CFD and Forex trading is now subject to a maximum permitted leverage of 1:30. According to the authority, the levers are chosen with volatility in mind and do not apply to professional traders. How high the leverage may be in concrete terms depends on the type of investment product. This is the maximum permitted leverage for currency pairs, commodities, indices, stocks and crypto currencies:
Maximum Leverage in CFD trading and Forex trading
The following maximum levers are legally defined for Forex and CFD trading:
- 1:30 for major forex pairs
- 1:20 for other currency pairs, gold and major indices such as DAX30, Dow Jones and S&P 500)
- 1:10 for other commodities and smaller indices
- 1:5 for shares
- 1:2 for crypto currencies
New Margin Close-Out Rules and Present Risk Warning
Since August 1, 2018, new Margin Close-Out rules have also been in effect, which, like the regulation of permitted leverage, serve to protect CFD traders. As soon as their total open positions exceed 50 percent of the required margin, all positions must be liquidated. Was there already a standardised margin close out before the new ESMA rules? No, until now brokers were able to decide for themselves when to close out their clients’ loss positions. There was therefore no standardised regulation.
In addition, since the new ESMA rules, CFD brokers must issue a standardised risk warning. This risk warning must state the percentage of traders who have lost money in the previous quarter.
CFD Broker: Comparison of costs and services for the CFD portfolio
To trade CFDs, interested parties need a CFD deposit with a broker or bank. A CFD broker comparison is recommended when choosing a suitable provider, as there are a number of things to consider.
- The CFD trading platform: Does your CFD broker offer software (CFD trading front-end) that has been specially developed for CFD trading and that scores points with its up-to-date range of functions? Investors should not miss out on free real-time prices and trading directly from the chart when trading CFDs under any circumstances. They are important for immediate and fast trading. Unfortunately, some brokers still charge price data fees, especially for the provision of real-time prices.
- CFD selection: An important criterion in the choice of a CFD broker is also the selection of CFDs and underlying instruments. How many indices, stocks, futures, currencies and commodities are available?
- Fees for CFD trading: An important aspect of choosing a CFD broker is also the fees that are charged for trading. Investors should check especially the fees per transaction, holding fees and minimum deposits.
- Compensation for overnight positions: When comparing CFD broker conditions, investors should also look at the conditions for holding overnight positions. In most cases, contracts for difference are not held for too long. However, there are significant differences in the compensation paid for holding open CFD positions beyond the close of trading (overnight). By the way: CFDs do not have limited terms and are therefore not subject to any loss in fair value – unlike warrants, for example. CFDs on futures with a defined maturity date are an exception.
- Spread when trading CFDs: Before opening a CFD account, take a look at the spreads for the individual underlying instruments – to be found in the price-performance list of your CFD broker. In most cases, the range of standard underlyings such as shares, currencies and commodities offered by different CFD brokers differs only marginally. However, the situation is different for investors who also want to trade CFDs on futures.
- Risk and Money Management: What risk and money management options does your CFD broker offer? Open a CFD account with a broker that offers innovative order additions such as trailing stops, stop-loss orders, limit orders or take-profit orders, the validity of which you as a CFD trader can determine individually.