CFD trading: what is it, and how does it work?
This article will take you through what a contract for difference (CFD) is, how it works, and its legality in the US.
Summary
A contract for difference, or CFD, is a type of financial contract common in investing and trading.
CFD trading is considered an advanced strategy and is primarily recommended to experienced investors.
CFD trading is illegal for US citizens and residents due to US securities law.
A financial advisor can help you choose the right investments for your portfolio and avoid any costly mishaps.
What is Contract for Difference (CFD) trading?
A contract for difference, or CFD, is a type of financial contract common in investing and trading. When two parties enter a CFD, an agreement is made to pay the difference between an asset’s current value and its value at contract time.
The CFD broker pays the investor if the closing price at contract time is higher than the opening price at purchase time. If the opposite is true, and the asset has decreased in value, the investor may need to purchase an offsetting trade to cover this.
How do CFDs work?
CFDs are cash-settled, ideal for short-term trading of securities.
As a CFD investor, you don’t own an underlying asset. Instead, you earn money from Exchange-Traded Funds (ETFs), stock indices and commodities based on their changing price.
Taking gold as an example, you’re not buying or selling the precious metal itself. Instead, you’re speculating on whether the price of that gold will go up or down in a given timeframe. You’re trading in price movements.
CFD trading is considered an advanced strategy and primarily recommended to experienced investors, partly because it can be challenging to get your head around and partly because it requires careful and calculated risk assessment. As a CFD trader, you’re constantly making bets on whether the underlying asset or security price will rise or fall.
If you’re interested in getting involved with this type of trading but unsure where to start, we’d recommend speaking with an experienced financial adviser before making any definitive moves.
Why are CFDs illegal in the US?
CFD trading is illegal for US citizens and residents.
One of the main reasons for this is due to a law imposed by the U.S. Securities and Exchange Commission (SEC). The Dodd-Frank Act was introduced to prevent the excess risk-taking experienced prior to the 2007-2008 financial crisis.
Reducing the risk associated with using over-the-counter trading products was another aspect of the Dodd-Frank Act and where CFDs come in.
Over-the-counter financial instruments, such as CFDs, are heavily regulated through legislation like the Dodd-Frank Act and enforced by the SEC. This is because these investment products do not pass through regulated exchanges, meaning the SEC cannot regulate how they operate.
CFDs are legal in other countries, including the United Kingdom, Canada, Spain, Germany, France and South Africa.
Knowing the ins and outs of US financial law is complex business. Working with a regulated and trusted financial advisor can take some of this pressure off. They know all the rules and regulations surrounding investments and can ensure you’re making legal decisions.
Unbiased can connect you with a financial advisor perfectly suited to meet your needs in less than 48 hours. Simply fill out a short questionnaire, and we will look after the rest. Match with a financial advisor here.
How much does a CFD cost?
The cost of a CFD itself is hard to define since it depends entirely on the pricing of the underlying asset or security. There are, however, CFD fees you’ll need to be aware of, and these should form an essential part of determining whether this might be a suitable investment route for you:
CFD commission fees are applicable to share CFDs when opening and closing (but not to indices, currencies, commodities and bonds).
Overnight financing fees are applicable when you want to hold a CFD for more than one trading day.
The Guaranteed Stop Loss Order (GSLO) charge is applicable if you’d like to guarantee your ability to exit a trade at a certain value.
What are the advantages and disadvantages of CFD trading?
CFD trading does have its advantages and disadvantages, including:
CFD advantages
CFDs allow investors to trade in price movement without taking full responsibility for an asset's price.
CFDs are incredibly varied, presenting investors with many potential routes and options.
CFD trading risks can be controlled, in part, by provisions like the GSLO (Guaranteed Stop Loss Order) mentioned above.
CFD disadvantages
CFDs are not available to US citizens and residents, meaning you cannot legally invest in the product.
There’s a high risk of losing money on a CFD trade, especially for less-experienced investors.
CFD trading regulations and fees can create a lot of red tape for traders to sort through.
Using CFDs as the basis for leverage on a bigger deal can increase your vulnerability to exponential losses.
Overall, the risk of trading in CFDs should never be understated, especially for beginner investors.
Get expert investment advice
As mentioned, CFDs are not a legal investment option for US citizens and residents, so it’s important not to include these as part of your investment portfolio.
However, from stocks and bonds to real estate and collectibles such as gold, art, and coins, there are plenty of other investment options open to those in the US.
For quality investment advice and guidance when building your investment portfolio, it’s best to speak with a financial adviser.
Senior Content Writer
Lisa-Marie Voneshen is a Senior Content Writer at Unbiased. She is an award-winning journalist with nearly a decade of experience writing and editing content across various areas, including personal finance and investing.