CFDs

Pros and Cons of trading CFDs

Contracts for difference (CFDs) are over the counter (OTC) derivative products which were initially introduced for hedging. However, they gained popularity in the Forex, commodities, futures and equities markets.

The concept is that the buyer and the seller exchange the difference in the settlement price of a given security. They are not suitable for long term portfolios of stocks and bonds.

I will go through some advantages and disadvantages of trading CFDs. I believe that it is important for market participants to understand the products they trade including any shortcomings and hidden fees.

CFDs Advantages

Ease of use

CFDs are widely available and easily accessible in the UK. It takes just a few minutes to set up and fund an account with one of the dozens of providers or with a few simultaneously.

There is no screening process and no knowledge is required to get you set up. Trades are free, there are no account fees, holding fees or transfer fees.

You may start to wonder how they make money, but don’t worry, I’ll cover this in the disadvantages section.

Market access

You have access to a wide variety of markets and instruments at your fingertips. Whether you fancy shares, indices, commodities or crypto, it’s all there.

It’s fine to trade in any currency because the CFD profit or loss just gets calculated against the forex spot rate of the GBP. Trading a fraction of a share is available so you won’t need thousands to trade Amazon, the FTSE 100 or oil.

Leverage

You can trade small but you can trade big too. The leverage you get when you open an account is between 1:4 (for individual stocks) and 1:20 (for indices), and you can increase it to up to 1:500. I haven’t checked what are the requirements to use 500x.

Margin requirements vary from 20% for stocks to 5% for indices. This means that you can trade 16 units of the FTSE 100 with £5,000, this is a notional value of £97,120 at the time of writing.

Execution and trading regulations

The order execution is excellent, market orders are very quick. Limit orders are filled the moment the stock hits your price target. One of the biggest advantages is that you don’t need to worry about some trading restrictions.

If you short a stock on the exchange you need to borrow the shares. This is fairly straightforward in most cases, however, the point is that you need the shares to be allocated to your trade.

Borrowing becomes a problem if the stock falls into the hard to borrow category. You are charged fees which can be well over 100% per year.

This doesn’t apply to CFDs, however, if the broker is hedging their exposure on the exchange you’d incur a very wide spread or you just won’t be allowed to short the instrument.

The US SEC Uptick rule doesn’t apply to CFD either so you can short stock anytime you want, however, you may again incur a wide spread.

Short selling bans apply to CFDs. I was unable to short any Paris listed stock during the coronavirus crash as the French government imposed a ban.

Another issue which is resolved with CFDs is the Pattern Day Trader rule. You need $25,000 in your account to day trade US stocks. This doesn’t apply to CFDs as they don’t get routed through an exchange. Your broker will be routing orders but they have more than 25K so that’s settled.

CFDs Disadvantages

I will start with the fact that these products were permanently banned in the USA. Last year the FCA here in the UK introduced restrictions to the leverage available to retail clients.

OTC vs Exchange traded products

Exchange traded products are better regulated compared to OTC products. There is a lot more certainty in an exchange routed derivative order than an OTC order.

The similarity is that you don’t need to worry too much about counterparty risk. Just make sure that you are using a reputable broker.

Is it really free?

I’m always suspicious of anything ‘free’, someone somewhere has to pay for it. CFDs are no different, you pay the bid ask spread.

There is a bid ask spread on the exchange too but it is narrower. Additionally, you can route an order at the mid price and there is a good chance you’d get filled. However, you pay for account maintenance, data and all sorts of other fees, you can find examples here.

The CFD spread varies between brokers. Some brokers use a dynamic spread which expands or contracts depending on market conditions.

You need to know that there are situations when the bid ask spread can work to your advantage and you can make more money by trading CFDs than traditional stock.

However, to achieve that you need to compare the exchange spread and brokerage fees with the CFD spread on a trade by trade basis.

Market maker CFDs broker model

Around 80% of retail CFD accounts in the UK lose money. It is noteworthy that an intraday stock trade has a 50% chance of success from a probabilistic perspective.

If I was a broker or a poker player I’d be looking at taking the opposing side of these trades. I can easily hedge my risk on the exchange. This is exactly what a lot of the brokers do.

On a positive note they create a market similar to the stock exchange market makers. They also take the opposing side of your trades.

Product deficiencies

CFDs are a fast moving product, I mean very fast. This is due to the high leverage. You need little margin to hold a position so the product creates a tendency to over leverage. Therefore, you have to be careful with the trade size.

In the example with the 16 units of FTSE100 a 1% move in the wrong direction will result in a loss of £971.2. You just lost 20% of your £5000 account. Now you’d need to make a 25% profit just to break even.

This can lead to revenge trading and further losses, a second trade like that and you need to make 66% to break even, a third one equals a blown account. I have seen people behave this way while gambling.

Another issue is the liquidity or the lack of it as some Swiss franc forex traders found out. Brokers went bust too.

If you trade on the exchange you’d know what is the volume of a stock, option or a future. So if the average volume is 10 shares per day you just don’t trade that stock. CFDs on the other hand don’t offer any volume data.

There is also a limited opportunity to hedge and/or risk manage positions unlike other derivative products which offer multiple options.

Trading interruptions

There are a limited number of situations which result in a trading interruption on the exchange, some of these are: a technical issue shut it down, a circuit breaker was activated, the stock got halted, there is a natural disaster.

These apply to CFD too, however, additional halts are less transparent as the broker can halt a given instrument whenever they choose, sometimes resulting in losses depending on which side you are.

Conclusion

I believe that every product can be used successfully as long as the investor understands it. CFDs provide an easy way to hedge other positions and to speculate on short term market moves.

They have advantages and disadvantages as any other product. Therefore, it is important to research them and establish if they fit your requirements prior to trading.