What are CFDs?
When learning about CFDs, it can help to think about what the name itself implies: a contract for a difference. A CFD is a contract that reflects a specific price for a given asset. For the duration that you hold the contract, the price for that asset may go up, or it may go down.
Depending on the difference between the initial price and the price at which you exit the contract, you'll either be paid out for that difference, or you'll lose money on the deal
For example: If you buy a CFD on the EUR/USD pair and the contract price jumps higher than your initial purchase price, your profit will be the difference between those two prices. Likewise, if your contract price for the EUR/USD drops below your initial purchase price, you'll incur a loss.
The price of the CFD trades just like the underlying market it tracks. So, a CFD for the EUR/USD pair will have nearly the same price as the actual currency pair (CFD traders may need to account for a minor degree of tracking error). The same goes for CFDs on other asset classes, such as shares.
Note: When you purchase an asset like company stock, you become the owner of those actual shares. When purchasing a CFD, however, you never actually own the asset itself. As mentioned earlier, you are only buying (or selling) a contract expressing a price difference for that asset. The associated (underlying) asset could be a company's stock, cryptocurrency, forex pair, market index, or a commodity like gold or oil.
Let's look at another example, but this time with stock instead of a currency pair:
Let's say you glanced at TSLA stock in October of 2021 when it hit $1,000. Your belief at the time was that it would hit, say, $1,200. You decide to buy a TSLA CFD.
Boom, it's November 1st, 2021, and TSLA has hit $1,200! You close your CFD position, netting a $200 profit (minus commissions, fees, and the spread).
Or, perhaps TSLA's stock ended up dropping from $1,000 to $800. What you hoped would be a profitable CFD has now produced a $200 loss.
To recap: CFDs are speculative contracts set up for the trader to pay the difference in the value of a particular underlying asset, between when the contract is agreed upon and entered into force, and when it expires (though the contract can be sold at any time).
Important reminder: CFDs fall into the high-risk category of the trading world you'll find that most sites (including ours; just scroll up) feature risk disclaimers specifically for CFDs (they really are that risky).
Why trade CFDs?
Traders decide to purchase and trade CFDs for a variety of reasons. Perhaps they are looking for an easier way to short sell an asset. They may be hoping for a convenient way to access a wider variety of trading products from within one brokerage account. Or, maybe they are just looking for access to lower margin requirements. Below, we'll spell out the reasons why CFDs can be a potential solution for these concerns.
Selling short: Under normal circumstances (without CFDs), if a trader expects the price of a given stock to drop (and wants to short sell), they'd need to borrow those shares from their broker and then sell them at the market price. The trader is hoping that the price of the stock does drop so that they can then buy the shares back at a lower price.
With CFDs, short selling operates under more or less the same principle, except the trader doesn't have to do any borrowing of any assets. Instead, they can simply create a sell to open order, which will open a new short position in the form of a CFD trade. Then, just like the above example, the trader waits for the price to drop before they buy and (hopefully) close the position with a profit.
Of course, if the market moves higher when selling short a CFD and the trader exits the position with a "buy to close" order, that trade would result in a loss. It may be simpler to sell short a CFD than it is for the underlying asset, but that doesn't make it less risky. In fact, the use of leverage can actually make it riskier - more on that next.
Leverage: Another reason investors may choose to use CFDs is for the potential leverage, the availability of which varies depending on the product you trade and the country you reside in (and any restrictions or leverage limits).
A leverage limit of 10:1 means an investor can control $100,000 worth of CFDs with just $10,000 in their margin account. This lower margin requirement means there is more capital available in their account to use (or risk) for opening additional positions.
As one can imagine, with a leverage ratio of 10:1, the potential for both gains and losses is significantly increased. Profits can soar fast, but losses can pile up just as quickly (hence the ever-present disclaimers that detail how risky it is to trade CFDs).
Product availability: Forex and CFD brokers are increasingly offering a wider selection of asset classes and a greater total number of available symbols for trading.
For example, you might have a trader who wants exposure to the price of Bitcoin but would prefer to avoid owning a cryptocurrency wallet and related exchange account. Instead, they can use a CFD as a means to get that exposure to Bitcoin. It's worth remembering that CFD trading does come with associated fees that may not be present when trading the underlying asset(s).
Pros & Cons of trading CFDs:
Pros:
- Wide range of markets. CFD traders can gain access to a huge range of markets – including instruments that may not normally be readily accessible, or typically available in your country of residence.
- Go long and short. With CFD trading, it's relatively easy to open a short (sell) position, allowing traders to potentially make money when an instrument goes down in price.
- Instant order execution. When trading CFDs, most orders are executed instantly with the click of a button, meaning there is less risk of slippage or requotes (though this depends on the type of order and your account's execution method).
- Low fees and commissions. Most CFD trading platforms charge a relatively low commission.
Cons:
- You can lose everything. While assets rarely plummet to zero in traditional stock or commodity trading, it's possible to lose your entire balance when trading CFDs, due to leverage.
- Overnight fees. CFD trading is not ideal for holding positions for long periods of time, as there are fees (known as carry charges, or overnight premiums) for holding a position overnight (again, due to leverage).
- Lack of ownership. When you buy a CFD, you own the contract – not the asset. So, you can trade Bitcoin without having a crypto wallet, for example, but you won't actually own those assets, and you aren't eligible for shareholder voting rights or dividends.
- Capital gains tax. Unlike spread betting (which carries no capital gains tax for U.K. residents), CFD trades are subject to capital gains tax.
How are CFDs different than investing in stocks?
When you purchase a stock, the shares are held by your broker on your behalf. You become the shareholder of record and are eligible to partake in certain voting and proxy meetings as part of the governance process. CFDs operate a bit differently, and there are some advantages that come with "real" stocks, and some that come with share CFDs. We'll sort out some of the differences below:
Regulatory requirements: Unlike share CFDs, exchange-traded shares may involve certain regulatory and exchange fees, reporting requirements, and disclosures (i.e., if you own more than 10% of a public company it triggers a filing requirement in the U.S.).
Dividends: Shareholders are eligible to receive potential dividends and other rights depending on the class of stock they hold (i.e. during a liquidity event or in the case of bankruptcy). When you are trading CFDs you have no such ownership rights or benefits. It's worth noting that some CFD brokers may still offer you the ability to receive dividends, in an attempt to mimic the trading of real (underlying) stocks.
Stock certificates: As mentioned above, CFDs can replicate much of the experience that comes with owning an underlying stock, albeit with some exceptions. One such exception would be stock certificates. As CFD traders don't actually own any of the underlying assets, they aren't entitled to a certificate of ownership for any stock. A relic of the past, stock certificates today aren't as crucial as they once were. Few investors request to physically own the real stock certificates to which they are entitled (unless they plan on voting during shareholder meetings).
Risk: Share CFDs - just like all CFDs - are risky investments, and carry additional risks that aren't present when trading underlying stocks. For example, during a fast market move, your broker may not have time to fill your position when trading a share CFD. Also, though your portfolio rarely plummets to zero when trading or investing in underlying stocks, it's possible to lose your entire balance (or even go into the negative) when trading share CFDs (due to leverage).
What is the spread?
The spread, or bid/ask spread, communicates the (often minuscule) difference between the buying and selling price for an asset (such as a currency pair). When you open a CFD trade, your online brokerage account will immediately show a loss equal to the size of the spread, because in that instant the rate that you'll pay to exit the trade is equal to the cost of the spread.
So, if the broker charges a spread of 10 cents, your CFD trade will immediately show a loss of 10 cents when opened.
The spread is the primary means for CFD brokers to profit from trading. Alternatively, they may charge you a commission, while passing your trade to another market-maker (who will in turn profit from the spread).
Either way, the spread is always crossed, even if it is close to zero. In other words, you'll always pay the spread, one way or another. It's important to always keep an eye on the spread, as this important trading cost can add up over time, whether on large positions or over the course of many trades.
What is leverage?
Leverage refers to a strategy in which traders control a greater amount of investment capital by borrowing funds, in what is known as a margin account. Each margin account will have different margin requirements, which indicate the maximum allowable margin ratio.
For example, if the margin requirement for a trading account is 100%, this means that a trader with $10,000 is allowed to buy $10,000 worth of securities. So, the ratio of capital to borrowed capital is 1:1.
If the margin account allows for a 10% margin (or, a 10:1 ratio), that same investor can control nearly $100,000 when putting down the same initial $10,000. The other 90% (or, $90,000 in this example) is obtained by borrowing money from a broker.
In other words, with $10,000 of your own funds (the required margin), a margin account with 10:1 leverage would allow you to open a position of $100,000 by borrowing from your broker.
Despite the potential for larger positions and larger profits, there is also the potential for larger losses. When using leverage in a margin account, there is the potential to incur a negative balance due to the large amounts of borrowed capital.
In the event of an abrupt market move against you, for example, that sudden loss may be greater than what your account balance can cover, thus creating a negative balance. Brokers often have automated liquidation mechanisms in place that are designed to help prevent a negative balance scenario, making it a somewhat rare occurrence - but it can still happen.
Pro tip: Every investor needs to be aware of the major risks that come with using leverage. Due to those risks - and the potential for big losses - leverage should only be used by experienced investors.
Are CFDs legal in the U.S.?
CFDs are not legal or permitted in the U.S. or to U.S. residents, irrespective of your broker's regulatory status. If you are not a U.S. resident, you can trade CFDs with most forex brokers that accept clients in your country of residence.
The closest analog to CFD trading in the U.S. would be trading on the futures and derivatives markets. CFDs are considered a derivative in the U.S. and fall under the jurisdiction of the U.S. Commodity Futures Trading Commission (CFTC), which requires that brokers meet the licensing requirements for offering derivatives.
The CFTC also regulates the spot forex cash market, which requires that U.S. residents trade with a U.S.-regulated forex broker. Futures brokers in the U.S. are regulated as Financial Commission Merchants (FCMs), and those that offer forex to retail clients must obtain the Retail Forex Exchange Dealer (RFED) license and become members of the National Futures Association (NFA).
It's important to note that not all spot forex transactions are considered CFDs. In the U.S. for example, spot forex transactions behave just like CFDs but are considered rolling-spot contracts for legal purposes. While you cannot access CFDs as a U.S. resident, it is important to know there are many alternative exchange-traded products that U.S. brokers offer that can provide you with similar exposure to underlying assets, including options, forex, futures, and securities.
What is the best CFD trading platform?
Saxo Bank offers the best forex and CFD trading platform in 2023, thanks to its SaxoTraderGO web and mobile suite, along with its equally impressive SaxoTraderPRO desktop platform.
Saxo Bank allows you to switch between shares, CFDs, and even options from the same trade ticket window when placing an order. Saxo Bank offers a whopping 40,000 tradeable symbols (including a massive list of CFDs), and its platform suite is loaded with trading tools, cutting-edge research, and powerful charting. Simply put, Saxo Bank is our favorite forex and CFD trading platform in 2023.
What CFD instruments can you trade?
There is an enormous number of possible CFD instruments that can be traded. IG and Saxo Bank are two great examples of award-winning multi-asset brokers that each offers immense CFD offerings. IG offers close to 20,000 CFDs, and Saxo Bank has a staggering 40,000 available symbols and a huge offering of CFDs.
Are there good CFD brokers?
The best CFD brokers are highly-regulated and a great choice whether you are a beginner or an expert trader. These trusted brokers offer the best platforms, product range, and trading tools, including research and client education, providing everything that CFD traders need.
At the same time, there are some brokers that are best avoided, due to their lack of licenses, minimal product offering, and narrow range of markets and services. That is why it is crucial to choose a highly-regulated broker for your CFD trading needs.
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To recap, here are our top forex brokers for 2023, sorted by Overall ranking.
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There is a very high degree of risk involved in trading securities. With respect to margin-based foreign exchange trading, off-exchange derivatives, and cryptocurrencies, there is considerable exposure to risk, including but not limited to, leverage, creditworthiness, limited regulatory protection and market volatility that may substantially affect the price, or liquidity of a currency or related instrument. It should not be assumed that the methods, techniques, or indicators presented in these products will be profitable, or that they will not result in losses. Learn more about foreign exchange risk.
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Joey Shadeck is the Content Strategist and Research Analyst for BrokerNotes.co and ForexBrokers.com. He holds dual degrees in Finance and Marketing from Oakland University, and has been an active trader and investor for close to ten years. An industry veteran, Joey obtains and verifies data, conducts research, and analyzes and validates our content.
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