3 Types of CFDs Explained

11 December 2018

Co-author: Canstar Research

CFDs can vary in the way they are executed, managed and structured. To break it down for you, we’ve explored three of the most common CFD types, each with key fundamental differences.

What is a CFD?

A contract for difference, more commonly known as a CFD, is a type of derivative that is used to speculate on the movement of a particular asset. For example, instead of buying any actual shares, you enter into a contract with another party to pay the difference between the asset’s current price and its value at a stipulated end time.

If, for example, you think that the value of a company’s shares will go up soon, you could enter into a contract for difference, to effectively place a bet on its share price rising. If you’re right, then your profit will be the difference between the original share price and the new price. However, if you’re wrong and the price falls, then you will have to pay the difference to the other party to the contract.

ASIC considers CFDs to be complex financial products with various risks involved. When considering if investing in CFDs is right for you make sure you do your research and take into account your own personal circumstances.

CFD structures

CFDs can be used to take a long position, where you expect the price to go up, and a short position, where you expect the price to go down. They can be based on the price of almost any financial instrument, but without the actual instrument changing hands. There are a few ways to structure a CFD, and two of the biggest models are Direct Market Access and Market Maker.

Direct Market Access

Direct Market Access (DMA) CFDs provide the prices and liquidity present within the underlying exchange (e.g. the ASX). DMA CFD orders are passed directly through to the physical market with no dealer or market maker intervention, resulting in real time execution and true market prices. This typically provides complete order transparency, allowing clients to see their orders processed in the underlying market.

Market Maker

A Market Maker (MM) CFD provider is just that, a Market Maker. They create their own market and prices which are based on the actual exchange. An advantage of trading MM CFDs is that they can provide quotes on stocks that may otherwise be difficult to convert to cash. They also have the ability to allow the trader to gain exposure to a wide range of exotic markets, indices and currencies plus the added protection of guaranteed stop losses. Furthermore because of the fierce competition present in the CFD market nowadays Market Makers also generally provide competitive brokerage costs.

Direct Market Access Market Maker
Structure Physical link to actual stock exchange Mirrored price to stock exchange
Pricetaker/maker Price maker, means that your trades are influencing the security price (your order are contributing to bid-ask price) Price taker, means that your trade do not contribute to bid-ask price
Liquidity Market liquidity Can provide a higher degree of liquidity
Cost Brokerage and financing cost Brokerage, financing cost and potentially additional spread on bid-ask price

Exchange traded CFD

A third type of CFD is exchange traded. Currently the only place that exchange traded CFDs are available is on the ASX.

This method provides an added level of protection because only CFDs listed, traded and cleared on ASX are used, providing a fully regulated and transparent market. CFD providers are also required to actually purchase the underlying asset, providing a hedge and perfect synchronisation with the price movements of the asset.

This also helps to eliminate counterparty risk – the possibility that the other party might not be in a position to actually pay the difference, even if the instrument being tracked moves in a profitable direction. Exchange traded CFDs are backed by the exchange no matter what, so you can’t ‘win’ and still make a loss.

There are two downsides for exchange traded CFDs to keep in mind though. One is that due to their heavily regulated nature, there is a more limited range of financial instruments that CFDs are available for. Secondly, take-up of ASX listed CFDs has been relatively low, meaning liquidity is also low.

What you should consider

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.

For more on trading CFDs, make sure to check out our dedicated page.

If you’re looking for a online share trading platform, you can compare platforms here:

Header image source: Mdd (Shutterstock)

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