Over the past decade, CFDs (Contracts For Difference) have become the most popular way for online investors to trade stocks, commodities, indices and currencies. As with everything that grows so fast, there is a lot of disinformation surrounding CFDs. Here we will go back to the basics to explain what a CFD is and what are its implications for investors such as yourself.
Most assets on eToro are traded as CFDs and are executed during specific market hours.
What is a CFD?
CFD stands for “Contract For Difference”. To put it simply, a CFD is an agreement between yourself and a broker to pay each other the difference between the price of an asset (such as Gold, EUR/USD, Microsoft stock, etc.) at the moment the contract is made and its later price when you decide to terminate the contract, i.e. close the trade.
It means that you do not own the actual asset, but rather, you engage in a contract with the owner (in this case, the trading platform), to settle the difference between yourselves when the deal has concluded.
This opens the door to many possibilities, such as fractional ownership of stock, short orders on assets that don’t offer short orders, and much more.
How do CFDs work?
The logic behind trading CFDs is pretty much the same as investing in any other market, like stocks for example. If the price of the stock goes up by 10%, your investment does the same. If on the other hand, the price of the stock goes down by 10%, your investment also loses 10% in value.
With CFDs, the major difference is that your investment is now a contract which offers you more flexibility than owning the real stock: You can apply leverage, set stop-loss and take-profit orders, and choose when to realise your gain/loss by closing the trade.
When investing in stocks using CFDs and no leverage (1:1), the deal carries no more risk than if you were investing in the actual stock.
Can I only profit when prices are going up?
No. One of the big advantages of investing in CFDs, rather than in markets like commodities or stocks, is that you can profit from falling markets as well. Remember, a CFD is a Contract For Difference, but that difference can go in any direction. So you can invest in the possibility of prices going up (a “buy” or “long” order) or down (a “sell” or “short” order), according to what you think is likely to happen.
Is the minimum investment in the stock equal to its market price?
No. CFDs make it possible to invest smaller amounts in the markets of your choice. With CFDs you don’t actually have to purchase or own an instrument, so you are not constricted by the high prices of certain stocks or commodities. So even if the price of Google’s stock, for example, is $1,000, on eToro you can invest in Google with as little as $50 (using leverage of 1:10) and own $500 worth of Google shares. That’s one of the greatest advantages of using CFDs.
Are there assets unique to CFDs?
Yes. Indices such as the DJ30 or the SPX500, for example, are not actual physical assets – you can’t own a piece of an index. However, with CFDs, you can speculate on index performances, which enables you to invest not just in one stock but in whole sectors of national economies.
Are CFDs riskier than traditional market investments?
No. Any financial investment involves risk, and CFDs are no different. CFDs only become riskier if you’re using leverage, thereby increasing your market exposure. On eToro for example, you can invest in any asset without any leverage.
Are CFDs necessary for Copy Trading?
Yes. CFDs provide the flexibility that makes it possible to execute copied trades while maintaining precise proportions between the copier’s allocated funds and the copied trader’s account. Without CFDs, if a trader you’re copying with $100 invested a portion of his account in Google stocks, for example, you would not be able to copy this trade, since one Google share currently costs over $500.
What’s the difference between a CFD and an ETF?
While there are similarities between CFDs and ETFs (Exchange-Traded Funds), they are quite different. The similarity is that they are both derivatives: An ETF is a fund which aggregates various financial assets into one tradable instrument, while a CFD is a contract regarding a price-change in a certain asset – meaning in both cases, you don’t actually purchase the underlying assets. However, while ETFs are composed by financial institutions following a specific market strategy (often used to hedge risk), a CFD is offered by a broker to enable access to private users. Similar to ETFs, CFD trading can be used to create a portfolio which follows a market strategy, giving the user absolute control over the assets they choose to hold, and enabling them to manage their own risks.