What are CFDs?

What are CFDs?

CFDs (Contracts for Difference) belong to the group of so-called derivatives or derivative financial instruments. They allow investors to bet on rising or falling prices of an underlying asset (such as a stock, an index, or a commodity) without buying the underlying asset. We explain the exact functionality of CFDs to interested readers in our guide “What are CFDs?”.

The fact that you can bet on the price movements of an underlying asset without having to buy it has several advantages:

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Advantages of CFDs and CFD trading

• CFDs are very cost-efficient, as there are no basic custody fees, order fees, or commissions.
• CFDs can also be used to buy fractions of an underlying asset. This allows investors to follow an underlying asset proportionally, even with low stakes.
• CFDs give investors access to financial markets that would otherwise not be available in this form (especially for commodity and currency markets).

Risks of CFD trading

The ban on CFDs with margin calls has made CFD trading safer. Nevertheless, trading continues to be very risky. In the worst case, it can lead to the total loss of the invested assets.

One of the hallmarks of CFD trading is leveraged trading. With some brokers, the leverage can be set up to 1:500. When a trader enters into a leveraged CFD on an underlying asset; they only need to deposit a fraction of what the underlying asset is worth at that moment as collateral (known as margin). This distinguishes the conclusion of a CFD, for example, from the purchase of a share.

If a share is priced at 100 euros, the share buyer pays these 100 euros (plus order fees). Conversely, if a trader concludes a CFD with a leverage of 1:10 on the same share, he only deposits ten euros as collateral.

If the share rises to 110 euros, the CFD trader has made 10 euros, thus 100 percent profit. If the percentage falls to 90 euros, the trader has lost his invested capital of 10 euros, i.e., a 100 percent loss. This is known as leverage or leverage.

This leverage amplifies fluctuations in the underlying asset’s price and makes CFD trading risky. Anyone who joins a CFD should inform themselves beforehand about the underlying asset and always be aware that they can lose the entire capital invested.

CFD broker with no obligation to make additional contributions

For a long time, the so-called margin call was one of the risks in CFD trading. In the event of unexpected events, such as the sudden depreciation of the Swiss franc, investors could face losses that exceeded their initial stake due to the leverage of CFDs. However, this is no longer possible. The German Federal Financial Supervisory Authority (BaFin) announced in December 2016 that it intends to ban CFDs with an obligation to make additional contributions. Brokers and other stakeholders had until 20 January 2017 to comment. There were a total of 30 comments. 11 of these came from CFD brokers and a provider association. Four were in favor of the measure, eight against.

On 08.05.2017, BaFin issued a general decree prohibiting CFDs with an obligation to make additional contributions. This meant that all CFD brokers had to implement a security system that would limit traders’ losses. No claims beyond the deposited security may no longer be demanded of the traders. The brokers were given three months to implement the requirements.

Since 10.08.2017, the ban on CFDs with additional margin calls has been in force. All brokers have converted their accounts by this date at the latest. At CMC Markets, this was also accompanied by a change in margins. However, a total loss of the invested capital is still possible. 

The effects of leverage in CFD trading

For many investors, the appeal of trading CFDs is the leverage already described. But this leverage can go either way. How strong the swing is in both the positive and negative directions depends on the price increase or fall of the underlying asset and the leverage, which is calculated as the reciprocal of the margin (leverage = 1 / margin). To illustrate these effects, we have put a table online below for various price changes and leverages:

Hint: Since 01.08.2018, legal regulations have imposed restrictions on leverage in CFD trading. Depending on the type of CFD, the power for private traders is limited to a maximum of 30:1! Columns F and G are only used to illustrate the leverage effect.

CFD brokers and CFD trading are becoming increasingly popular

CFDs are an invention from the 1990s. Hegde Funds wanted to use them to carry out short sales on shares without paying the British stock exchange tax due at the time. 

Which underlying assets are chosen for trading

In CFD trading, investors rely almost exclusively on indices. According to the quarterly survey by the German CFD Association, stock indices such as the DAX accounted for 2021.87 percent of all transactions in 5. The remaining 12.5 percent was divided between foreign exchange (7.6 percent), commodities (3.7 percent), equities (1.0 percent), and other (0.1 percent). The share of bond CFDs was 0.0 percent.

Five tips on how to trade CFDs successfully

1. Only trade with underlying assets that you know!

If you want to trade CFDs, you need to understand and assess the performance of the underlying asset on which the CFD is based. Naturally, this is easier for indices than for individual stocks and is probably why almost 93 percent of all trades in CFD trading are indices accounted for by indices. Underlying such as the companies from the DAX40 – such as Munich Re or Daimler – can also be assessed well. Therefore, only rely on underlying assets you know or whose development you can determine well!

2. Start with a bit of leverage!

The exciting thing about CFD trading is that you can move prominent positions with little equity – leverage makes it possible. Like a door, however, the lever can swing in both directions. Therefore, our advice: start with a small lever and increase it slowly. A slightly lower profit than an excessive risk of total losses or margin calls is better.

3. Always pay attention to the broker’s margin call!

If a CFD trade does not work out and the money in the trading account is insufficient to settle the losses, you will receive a so-called margin call from the broker, i.e., a request to close the position or inject more capital. Always pay attention to such margin calls; closing the position is best. Injecting capital only makes sense if you are sure that the trade will work out after all. Otherwise, it means throwing good money after bad money.

4. Loss limitation is mandatory!

Limiting losses is essential. Therefore, only trade with a stop price. More and more CFD brokers are now offering guaranteed stop prices, upon which the position is closed. In our comparison of reputable CFD brokers, you will find information from our editors in the column “Hedging systems” regarding which broker offers which hedging systems.

5. First demo account, then real money account!

If you are trading CFDs for the first time, you should do so with a demo account. Almost all brokers offer demo accounts, where you can practice trading CFDs extensively with virtual money. Once you have internalized the principle and found your underlying assets, you can start trading with real money.

With these seven criteria, you will find the right CFD broker.

1. What is the minimum deposit?

To participate in CFD trading, you must deposit a minimum amount as part of the account opening process. The amount of the deposit varies from broker to broker.

2. What is the maximum selectable leverage?

CFDs are traded with leverage. This means that only a small part (the margin) of the total value of a position is deposited. So, you can trade a much more prominent role with a small stake. Some brokers offer you the opportunity to determine the leverage individually. For others, the height of the leverage is predefined.

3. What underlying assets does the CFD broker offer?

You can participate in other markets by trading on the underlying asset classes. Most brokers offer CFDs on all known underlying assets, such as stocks, indices, commodities, or currencies.

4. What are the spreads of each broker?

The spread is the difference between the buy and sell price. Most CFD providers do not charge any fees other than the spread. The lower the spread, the less costs you will incur.

The respective amount varies and can vary greatly depending on the market conditions. You can also see the minimum spread for CFDs that track the DAX, as they are trendy.

5. What are the transaction costs?

In addition to the spread, a commission is charged for some instruments, essentially stock CFDs.

6. What are the financing costs?

If you want to hold an open CFD position beyond the close of trading, the broker will charge you an additional fee.

The calculation is based on the total value of your position held at the close of trading.

If you take a long position, you will be charged financing costs. In the case of an open short post, you will usually be paid a credit. Each broker uses a different interest rate. The amount of the individual financing costs can be found in the comparison.

7. Does the broker offer a demo account?

With a CFD demo account, you can test the broker’s respective trading platform with virtual capital under real conditions without risk.

Five tips on how to trade CFDs successfully

1. Only trade with underlying assets that you know!

If you want to trade CFDs, you need to understand and assess the performance of the underlying asset on which the CFD is based. Naturally, this is easier for indices than for individual stocks and is probably why almost 93 percent of all trades in CFD trading are indices accounted for by indices. Underlying such as the companies from the DAX40 – such as Munich Re or Daimler – can also be assessed well. Therefore, only rely on underlying assets you know or whose development you can determine well!

2. Start with a bit of leverage!

The exciting thing about CFD trading is that you can move prominent positions with little equity – leverage makes it possible. Like a door, however, the lever can swing in both directions. Therefore, our advice: start with a small lever and increase it slowly. A slightly lower profit than an excessive risk of total losses or margin calls is better.

3. Always pay attention to the broker’s margin call!

If a CFD trade does not work out and the money in the trading account is insufficient to settle the losses, you will receive a so-called margin call from the broker, i.e., a request to close the position or inject more capital. Always pay attention to such margin calls; closing the position is best. Injecting capital only makes sense if you are sure that the trade will work out after all. Otherwise, it means throwing good money after bad money.

4. Loss limitation is mandatory!

Limiting losses is essential. Therefore, only trade with a stop price. More and more CFD brokers are now offering guaranteed stop prices, upon which the position is closed. In our comparison of reputable CFD brokers, you will find information from our editors in the column “Hedging systems” regarding which broker offers which hedging systems.

5. First demo account, then real money account!

If you are trading CFDs for the first time, you should do so with a demo account. Almost all brokers offer demo accounts, where you can practice trading CFDs extensively with virtual money. Once you have internalized the principle and found your underlying assets, you can start trading with real money.

With these seven criteria, you will find the right CFD broker.

1. What is the minimum deposit?

To participate in CFD trading, you must deposit a minimum amount as part of the account opening process. The amount of the deposit varies from broker to broker.

2. What is the maximum selectable leverage?

CFDs are traded with leverage. This means that only a small part (the margin) of the total value of a position is deposited. So, you can trade a much more prominent role with a small stake. Some brokers offer you the opportunity to determine the leverage individually. For others, the height of the leverage is predefined.

3. What underlying assets does the CFD broker offer?

You can participate in different markets by trading on the underlying other asset classes. Most brokers offer CFDs on all known underlying assets, such as stocks, indices, commodities, or currencies.

4. What are the spreads of each broker?

The spread is the difference between the buy and sell price. Most CFD providers do not charge any fees other than the spread. The lower the spread, the less costs you will incur.

The respective amount varies and can vary greatly depending on the market conditions. You can also see the minimum spread for CFDs that track the DAX, as they are prevalent.

5. What are the transaction costs?

In addition to the spread, a commission is charged for some instruments, essentially stock CFDs.

6. What are the financing costs?

If you want to hold an open CFD position beyond the close of trading, the broker will charge you an additional fee.

The calculation is based on the total value of your position held at the close of trading.

If you take a long position, you will be charged financing costs. In the case of an open short post, you will usually be paid a credit. Each broker uses a different interest rate. The amount of the individual financing costs can be found in the comparison.

7. Does the broker offer a demo account?

With a CFD demo account, you can test the broker’s respective trading platform with virtual capital under real conditions without risk.