CFD stands for "Contract for Difference".
A contract for difference is an arrangement made in financial derivatives trading between a buyer and a seller. The buyer of the CFD must pay the seller the difference between the opening value of the trade and its value at the time of closing the trade.
Trading in CFDs allows traders to potentially generate a profit from price movement in a financial asset without actually owning the underlying asset. Traders can do this because the value of a CFD contract does not take into consideration the asset's underlying value; rather, it only takes into account the price difference between the trade entry and exit.
Most traders will execute a CFD trade through their retail broker platform where the broker will take the counterparty risk on the trade. Most brokers allow CFD trading on all kinds of financial products such as Forex, futures, stocks and shares, commodities, indices and cryptocurrencies for example.
CFDs and the United States
For different countries, different rules apply but for the U.S. CFDs are not legal to trade for American citizens both domestically and on foreign platforms regulated outside the U.S.
Both the Commodity Futures Trading Commission (CFTC) and its overseer, the Securities and Exchange Commission (SEC) strictly prohibit citizens from opening CFD accounts. CFDs are not legal because they are not regulated like the underlying stocks, bonds, commodities and currency pairs they represent. They are considered over-the-counter (OTC) financial instruments which are regulated by the Dodd-Frank Act.
U.S. regulators appear to have concerns about the high amount of leverage that can be built into CFDs and would prefer that citizens trade the less leveraged regulated products that already exist and have been around for a long time such as stocks and futures. They want traders' to have lower levels of leverage in an attempt to reduce potential losses and investment risk for its citizens.
Even though U.S. citizens are not allowed to trade CFDs, U.S.-based brokers can offer CFDs to non-U.S. citizens. Because of this, there have been many U.S. citizens that have gone to offshore brokers that will allow them to open CFD accounts. This typically means that the U.S. citizen will be trading on a broker that does not offer much in the way of legitimate regulation and could run the risk of losing their money to a scam broker. However, strongly regulated brokers regulated by the Financial Conduct Authority (FCA) of the UK will not allow U.S. citizens to open a CFD account.
Pros and Cons of CFDs
Pros
Leverage: If a trader has access to higher amounts of leverage this means that the money they have in their account will have much more buying power than the actual account cash balance. This means that they can buy larger trade sizes and potentially make more money per trade.
Available in many Markets: Typically, CFDs are globally available in many financial market centers. Depending on the broker they may choose to offer as many as 4,000 market options with uninterrupted access 24 hours per day 5 days per week.
Low Capital Requirements: Traders can open a CFD account with a relatively small amount of money compared to the other types of accounts offering different financial assets. Typically, CFD accounts have almost no trading requirements other than maintaining a positive account balance and you are free to trade just about any strategy.
Fair Playing Field: Traders have a choice when trading CFDs because the trading conditions do not try and force them into doing what they do not want to do. Traders are free to go short any financial asset that is offered as a CFD with no penalty or charge. In many traditional stock markets, it is difficult to get short.
Flexibility: The flexibility of trading a CFD provides more potential for efficiency. Brokers who offer CFDs can have more than the conventional stop loss and take profit orders. In many cases, they offer other order types to their customers such as “cancel if x action takes place” or “trailing stops”.
No Shorting Rules or Borrowing Stock: Certain markets have regulations that prohibit shorting and/or force the trader to borrow the financial asset before selling it short. This is in addition to having different margin requirements for short and long positions. However, CFD traders can go short at any time without borrowing costs since the trader doesn’t own the underlying asset.
No Pattern Day Trading Rules: Certain markets and jurisdictions like the US stock markets demand a minimum amount of capital to day trade or limit the number of day trades allowed to be made within a certain time period. These restrictions do not apply to the CFD market.
Many Trading Opportunities: Many brokers offer trading products such as shares, index, treasury, forex, cryptocurrency, and commodity CFDs. This enables speculators interested in a diverse range of financial instruments to trade CFDs as an alternative to trading on exchanges.
Cons
Leverage Risks: This is a take the good with the bad situation. As much as leverage can help grow accounts it can also destroy capital quickly. Trading with CFDs can be fast-paced, demanding that traders pay close attention to their positions. Traders will need to make sure that they maintain enough margins in their accounts to support all of their open positions. If the trader cannot cover the margin requirements then the broker will close any offending positions.
Regulation: The CFD industry is typically regulated by the most reputable regulators. However, there are many jurisdictions that brokers claim to be from that do not regulate CFDs. Traders should be careful and perform due diligence on the brokers that they want to open a CFD account with. There are many good brokers but there are many bad brokers as well. Extensive checks should be done on how the broker you choose does business and handles your money. A CFD broker’s credibility is not based on government standing or liquidity but rather reputation, longevity, and financial position.
Risks: Trading CFDs is currently not allowed in the United States. That is because it is not industry regulated. This means for those who do trade in CFDs it is high risk. CFDs can be fast-paced and careful attention needs to be paid to margin requirements or traders risk losing a significant portion of their accounts balance.
Traders Pay the Spread: Paying the spread on entries and exits takes away some of the opportunities to profit from small moves in the market. The spread will reduce winning trades by a small amount and increase losses by a small amount. Traditional markets will expose traders to various fees, regulations, commissions, and higher capital requirements, but CFDs will reduce the traders’ profits via spread costs.
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