Types of CFDs explained: What are they?

According the the most recent ASX Investor Study, about 6.6 million Australian adults, or 35% of the population, now hold listed investments. Clearly, as investors become more active, they will also want greater portfolio diversification. It’s not hard to see the appeal of stocks and ETFs for investors. But CFDs have a few key advantages, which means they could make a useful addition to investors’ portfolios as Saxo expert explains.

What is a CFD?

CFD is short for ‘contract for difference’. A CFD is a derivative product that enables you to trade financial markets, including stocks, forex, indices and commodities, without having to own the underlying assets.
When you trade a CFD, you enter into a financial contract with a broker to exchange the difference in the price of an underlying security (such as stock) from the moment you enter the trade to the moment you exit it.

For example, if you think Apple’s share price (Apple Inc.) will go up in value, you can buy a stock CFD in Apple, at the current market price. If Apple share price rises and you sell your CFD at a higher price, your broker will deposit the difference into your account. While that might sound like standard stock trade, trading a CFD offers some unique advantages, which we’ll explore in more detail below.

Key advantages of CFDs vs buying stocks

There are two major advantages CFDs offer: leverage and shorting.

1. Leverage

CFDs enable you to increase your purchasing power as you can trade them on leverage. This means you only need to put up a fraction of the full value of your trade – the ‘margin’ – to gain full exposure.

ASIC has regulated the maximum CFD leverage available to retail clients, ranging from 30:1 to 2:1. For example, the leverage for CFD on stock is 5:1, this means that with AUD 1,000 in capital, you could gain exposure to AUD 5,000 worth of stocks. That’s five times what would be possible with a conventional stock trade.
Be aware that while this additional exposure amplifies potential profits, the potential loss is also increased.ds

2. The ability to go long and short

When you buy stocks, you can only make a profit when markets are rising. And markets almost never go up in a straight line. When you trade a CFD, however, you can speculate on price movements in either direction. This is known as going ‘long’ (if you back a price rise) or ‘short’ (if you believe the market will fall).

So, if you think the share price of BHP (BHP Group Inc) is going to fall, you could short it by ‘selling’ a stock CFD. You can do this because CFDs are derivatives, and you don’t need to actually own any BHP shares to sell a CFD based on their stock.

If you’ve sold a BHP CFD, and the company’s shares fall in price, you can profit by buying the CFD back at a lower level and pocketing the difference between your entry and exit prices. Remember that the reverse is true, so if BHP shares rise, and you hold a short position you will make a loss.

The chart below illustrates the difference between a long and a short position and how it’s possible to profit from both rising and falling markets.

Long and short positions — *Source: Saxo Capital*

Access to a wide range of markets

If you want to speculate on the financial markets, you don’t need to limit yourself to exchange-traded products such as stocks and ETFs. Generally, you can trade CFDs on a much wider range of assets. CFDs are available on stocks, stock indices, forex, commodities, options and bonds.

Around-the-clock trading

When you deal with shares, you are constrained by the opening hours of the corresponding stock exchange. That leaves you exposed to the risk of overnight price moves due to unexpected market events. You can trade CFDs whenever the underlying markets are open – stock CFDs for instance are available for trading when the associated stock market is open. Some brokers offer CFDs on stock indices such as the UK 100, US 30 or Hong Kong 50, trade round the clock– so you can hedge or trade unexpected market events as they happen.

Immediate cash settlement

Unlike stocks, CFDs don’t have a settlement period. That means your profit or loss is calculated as soon as you close your position. This makes it much easier to enter and exit trades and allocate your resources quickly to your next position. With stock positions, on the other hand, it can take up to two days for your trade to settle and for you to gain access to your capital

Risks to be aware of

It’s important you’re aware that the value of CFDs can go down as well as up. As with other complex products, CFDs come with a high risk of losing money rapidly due to leverage. You should consider:

Whether you understand how CFDs or any of our other products work
Whether you can afford to take the high risk of losing your initial investment

What you should consider before trading CFDs

Due to their complexity, CFDs aren’t suitable for everyone, so it’s worth considering your individual needs and circumstances and making sure you understand the risks involved before deciding if CFDs are right for you.

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This article was reviewed by our Content Producer Isabella Shoard and Content Producer Marissa Hayden before it was updated, as part of our fact-checking process.

Eleanor Creagh

Senior Economist, REA Group

Eleanor Creagh is a Senior Economist at the REA Group. She previously was Senior Market Strategist for Saxo Markets and has been working as an advisor since 2015. Eleanor regularly shares her market views via events and television, including ABC and Bloomberg.

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