What are CFDs? CFD or Contract for Difference is
an agreement between a broker and a client to pay
the difference between a security’s opening and
closing price.
As investing moves online, digital platforms offer
CFDs as an innovative trading solution. CFDs have
many similarities to traditional trading, but the
differences make CFD trading popular and essential
to next generation investing capabilities. Online
CFD trading platforms, such as eToro, allow retail
investors:
• Access to multiple markets around the globe
• Currency and commodity trading
• Leveraged trading
• Low entry price trading
• Flexible long and short positions
CFDs are derived from futures contracts. A futures
contract is an agreement between two parties, who
agree on a price for a certain stock or commodity
when opening the contract. Yet they complete,
or settle, the actual transaction sometime in the
future. CFDs do this in an easy and cost effective
way. You don’t need large amounts of capital, or
the expertise that institutional investors possess.
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Instead, your trading can harness the power of
technology, transparency, and crowd wisdom. CFD
trading, which enables fractional shares, exible
long and short positions, and is done in real-time,
offers investors advantages that do not exist in
traditional trading.
Early forms of futures contracts date back before
the ancient Babylonians, some 3,800 years ago.
The futures contract was created as a hedging tool.
It enabled both parties in a transaction to protect
their investment. At that time each contract was
unique. It was arranged one contract at a time
between individuals. They were used in Japan in
the 1600s, and the tradition of individual contracts
continued up until the late 19th century. In 1865,
the Chicago Board of Trade (CBOT) changed the
game.
The CBOT, an exchange hub for most of America’s
mid-west grain farmers, began to standardise
futures contracts. They graded quality of wheat,
corn, and other commodities and they established
a standard measure of grain. That way, one
contract from farmer Jones was the same size and
quality as one contract from farmer Smith. This
made the contracts interchangeable. Buyers could
trust quality and size, and it no longer mattered
from which farm the grain came.
Standardisation of Contracts: This standardisation
of contracts gradually expanded to other assets.
In the late 1960s, non-agricultural commodities,
including raw materials such as gold and oil, began
to be traded with futures. The futures market
met the needs of buyers and sellers such as oil
companies selling to airlines, or miners selling to
manufacturers. The seller locked in a fair price
for the commodity. And the buyer could budget
expenses knowing the cost they’d have to pay for
the product.
11.1 The History of Futures Trading
137
But soon banks and investors saw it as a profit
play. The underlying asset (corn, oil, gold) is much
less important than the movement of the price.
Bankers never intend to own the asset. They just
want to make a profit on the risk and volatility.
If you believe the price of a commodity could go
up, you simply buy the contract that guarantees
it at a lower price. Then you look for it to rise and
profit from the difference. This was the beginning
of CFD trading as we know it today.
The Rise of the Foreign Currency Exchange
Market: Another turning point in trading came
with the end of the gold standard. In 1971, the
Bretton Woods system collapsed. This system
pegged all currencies to each other, based on the
price of gold. When it failed, currencies became
highly volatile, so they offered another financial
instrument for trading. This opened the oodgates
for the expansion of the futures markets and
created many new financial instruments.
Over the years, many forms of futures were
conceived on Wall Street. Then things morphed
again. If you could trade on the underlying asset
of commodities, why not trade other assets such
as stocks or indices? These assets have no actual
physical materials to exchange. But traders didn’t
want the asset. They wanted to settle accounts
in cash. This type of futures transaction became
known as a contract for difference (CFD). It, too, and
has opened a wide array of financial opportunities
for investment.
Reserved for Institutions: Futures contracts
and CFDs are widely used in markets around the
world. Currently, 92% of the world’s 500 largest
corporations use them to manage risks. Futures
contracts today cover a variety of asset classes and
span virtually every aspect of global trading.
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While the principle of futures and CFDs are still
the same, new innovation and technology are
changing the landscape. Banks and corporations
have been developing more elaborate investment
instruments. The majority are tailor-made
according to the bank or corporation’s specific
needs, as securitization tools.
For decades, financial institutions had the upper-
hand over individual traders by using futures
CFDs. It gave them access to markets around the
world. They were able to manage their risks and
diversify their portfolios more easily. Even with
the advent of digital banking and global finance,
futures contracts stayed in the realm of financial
institutions. They remained an obscure and out-
of-reach tool for most investors.
Futures Come to Individual Traders: One of the
biggest barriers for the individual trader of futures
contracts is that the contracts work in bulk. This
means a trader has to spend a substantial amount
to buy a whole contract. Similarly, the price of
one share in a major corporation could be in the
hundreds of dollars, locking out private investors
who don’t have the required capital. One of the
main benefits of CFDs is that there’s no actual
ownership of the asset by the end user. With CFDs
you can trade commodities and other assets in
fractions, rather than purchasing the entire share
or futures contract. This opens opportunities for
smaller individual traders.
Next, CFDs have recently expanded to virtually all
asset sectors. This allows traders to choose from
a wide array of securities spread across the world.
CFDs aren’t limited to your country’s exchange.
You can trade on assets in the Shanghai Stock
Exchange as easily as you trade on the London
Stock Exchange or the New York Stock Exchange.
Again, it’s because you aren’t trading the actual
asset, just a CFD based on the underlying asset.
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Finally, CFD trading became available to individual
investors via the Internet. Now people can trade
various assets and have a diversified portfolio, one
much broader than ever before possible.
Essentially, CFDs evolved from being just another
form of contract to the most technologically
advanced asset on the market. Online platforms
act as a mediator by obtaining the rights to the
asset, usually from a liquidity provider, and then
entering into a CFD with the end client. The
underlying asset never changes hands - even when
it is a commodity.
Regulation: Recently governments have stepped
in with increased regulations for CFDs and their
trading platforms to better protect the traders.
Financial Instruments Directive (MiFID) extended
coverage of the European financial services to
CFDs. Expect quality platforms to hold a European
MiFID license (CySEC) and a British FCA license to
give users the highest levels of compliance and risk
management.
Financial advisors may tell you that traditional
trading can accomplish as much as CFDs but CFDs
have some unique advantages. Let’s take a look at
the traditional and CFD benefits and limitations.
Dividends: Owing stocks entitle you to dividends
and special distributions. While CFDs do not
confer ownership, some brokers, like eToro, offer
dividends on stock CFDs. The dividend is credited
to your available balance based upon the amount
of shares you hold.
Going Short: Traditional ownership offers options
trading as a method of shorting a stock, but not all
assets have options. Some ETFs theoretically act
like a ‘short.’ They are designed to go up as the
11.2 Asset Ownership vs. CFDs
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portfolio of stocks they follow go down. But they
are only effective on a very short term basis. And
the range of assets you can short is narrower than
with CFDs.
Because CFDs operate independent of the market,
individual traders can perform actions that don’t
exist in traditional trading. For example, they could
open short positions (to profit when an asset’s
value drops down) even for assets that do not
offer options in traditional markets. Moreover,
CFD traders can use very exible ‘stop loss’ and
‘take profit’ orders, which automatically stop a
transaction when it reaches a predetermined profit
or loss point.
A good example could be the subprime mortgage
crisis. When the U.S. housing market crashed in
2008, several investors foresaw the event and
were able to profit from it by convincing investment
firms to create a collateralised debt instrument
(CDO) that could short sell the mortgage market.
However, today, one could simply use a CFD
platform to open a short position without the
hassle of dealing with financial institutions or big
banks.
Leverage: Traditional investors can use options
as a method of leveraging. A very small investment
allows them to control thousands of euros worth
of shares. However, they are limited to individual
stocks. Typically ETFs, indices, and many smaller
stocks cannot be leveraged with options trading.
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Online trading platforms offer leveraged
transactions with CFDs. Traders can use a small
amount of money to control a wide range of assets.
This includes currencies, commodities, stocks,
indices, cryptocurrencies, and assets from across
the globe. While this is a good opportunity to make
substantially more money than the actual capital
the trader has, it is also a double-edged sword.
Traders can also lose all their money and more.
Diversification: Traditional investing gives people
a good range of choices. They can buy individual
stocks, mutual funds, exchange traded funds, and
some commodities and real estate that are held
in a fund.
They can choose a selection of international assets
and a few foreign country specific stocks. Often
these foreign assets trade ‘over the counter’ (OTC).
This means you have to match buyers and sellers
one-by-one without brokers or traders, so fewer
shares are available to buy or sell making the market
lower volume, ‘less liquid,’ and more expensive.
Because CFD platforms are not subject to one
specific market, each trader can diversify their
portfolio to assets from different classes and various
locations, and even virtual cryptocurrencies, such
as Bitcoin, Ethereum, and Litecoin. All these assets
are available on one platform. There’s no need to
search for OTC ticker symbols. You don’t need to
deal with securities laws of foreign countries, tax
liabilities, or legal statements in other languages.
Transactions on these platforms are instantaneous
and highly liquid.
Fees: Traditional investor fees vary. Some pay
a fixed percent of the assets in their portfolio,
perhaps 2-3% each year. Some pay 5-6% on each
trade. Even online discount brokers charge about
$10 per trade. Savvy investors may be able to pay
less, especially for options trading.
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CFD’s on the other hand, only charge the spread.
This may be as small as a few cents per share.
Because of the number of users and the frequency
of trades, online platforms can more easily offer
these reduced commissions. It can make trading
CFDs more profitable even when trading small
amounts of assets that produce minor gains.
Trading Platforms: When you go on your trading
platforms, you’ll find very little difference between
buying and selling actual assets or CFDs. The look
and feel of the platforms are easy to use. The
choice to use leverage is the clue you are trading
CFDs instead of other assets.
One popular use of the social elements on
investment platforms, invented by eToro, is
CopyTrading. CopyTrading lets those with some
money, but little time or experience, invest their
funds by following and copying other successful
traders automatically in real time.
This practice differs from traditional asset-
management, where a portfolio manager is
managing other people’s money. With copy
trading, the traders that are being copied are
actually trading and risking their own money. When
platforms ensure copied traders don’t benefit
from gains or losses of their copiers, they align the
interests of the copiers and traders.
The leading social trading platforms today are fully
regulated. They offer full transparency and best
execution practices that promise their investors
will often receive a higher standard than traditional
brokers. Even with this high standard, remember
that all trading involves risk. Only risk capital you are
prepared to lose and past performance does not
guarantee future results. International economics
expert, Dr. Nouriel Roubini concluded in a recent
research that by 2021, 37% of investors expect to
be using social investing and trading platforms.
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All trading puts your money at risk. It also gives
you the potential for profits. Before you start, here
are some things that increase your likelihood of
success.
Trading Platforms: Not all trading platforms
are the same. You want to ensure you are going
with the highest quality. It is vital the platform is
transparent. Some things to check for include:
• How many traders are on the platform?
• How quick and liquid is the trading?
• What legal rules are they governed by and agree
to adhere to?
• How much support and help can they give new
or experienced traders?
• How easy is the site to use? Is it intuitive to
navigate?
How many assets are available to trade? Can
you do currency, commodities, cryptocurrencies,
indices, ETFs, stocks?
• Do you have experienced traders to follow?
Educate Yourself: Since many people use CFDs
with leverage, it’s essential you understand how
leverage works. It can add to your wealth, or it can
destroy it. You need to know how to use it based
on your portfolio size and risk level. We’ll discuss
this in the next section.
You also need to develop a trading strategy. Most
people who use CFDs are short term traders or
day traders, although CFDs can be used in buy-
and-hold strategies if you use no leverage. In order
to find more success in trading, you need to know
how to use technical analysis. This analysis will help
you find entry and exit points.
Most pros recommend practising your strategy in
virtual accounts. There you can experience real-
time trading without risking actual capital. You can
also backtest your strategy by going into the history
of your asset to see how often the strategy would
have given you wins… and how often it failed and
11.3 Before You Begin Trading
144
produced losses. Learn more about day trading
and swing trading if you want to make frequent
trades.
While you’re educating yourself, you can also follow
the trading of others to learn their strategy through
eToro’s CopyTrading opportunities. This gives you
a chance to invest while you learn.
More and more traditional industries are shifting
to the digital world, and investing is no different.
The technological trend which made CFD trading
available to almost anyone is still ongoing and will
enable its expansion to new markets and attract
new traders. When trading on a reliable, regulated
digital broker, traders can take advantage of its
exibility, transparency, and social tools such as
copy trading.
Online trading is a great tool for a new type of
investor. This is one who easily operates from their
own home anywhere in the world, and harnesses
the power of the crowds. eToro, the world’s leading
social trading network, sets a fine example of
delivering the future of trading and investing today.
Be sure to consider this award-winning platform.
Since the launch of CopyTrading by eToro in 2010,
124 million transactions have been copied, with
an 80% success rate. Still, it helps to remember
all trading involves risk. Only risk capital you are
prepared to lose, and past performance does not
guarantee future results
One of the draws for CFDs is their ability to use
leverage. Leverage is often called a two-edged
sword. It can magnify your profits or your losses.
11.4 Using Leverage
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What is Leverage? People use leverage in their
daily lives. If you buy a house on credit, you’ve used
leverage. It’s borrowing money and using a small
amount of money to control a large amount of
assets. With your home, you may put 20% down
(£40,000) and now you have the use of £200,000
worth of the home. Homeowners thought homes
would always go up in price. But when the housing
bubble came, they could not find buyers at the
price they wanted and the home dropped in value.
They were underwater on their loans, owing more
than they could sell for. This is both the advantage
and the danger of leverage.
With CFD, stock, or Forex leveraging you have the
same abilities. You can use a small portion of your
assets to control a large amount of securities. It’s
possible to have an enormous amount of leverage.
Here is a chart showing the profit/loss created by a
1% change in the underlying asset, depending on
the leverage used.
How Much Should I Use? Most traders recommend
novices start without any leverage at all. This is
the lowest risk way to trade CFDs. It makes your
potential profits lower, but it also reduces your
losses. This lets you practice your strategy while
reducing the chance you will ‘blow up’ your account
or lose all your money.
Leverage
% Change in
Asset
% Change in
Account
100:1 1% 100%
50:1 1% 50%
33:1 1% 33%
20:1 1% 20%
10:1 1% 10%
5:1 1% 5%
3:1 1% 3%
1:1 1% 1%
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Even as you gain greater skills, many traders only
use 3x leverage or perhaps 10x at most. The more
the leverage, the greater the swings you will see
in your portfolio. Profitable trades will swell your
assets, and then a losing trade will give you a deep
drawdown. The general rule of thumb is to base
your leverage level on these factors:
• Skill level
• Risk tolerance
• Capital invested
Studies have shown that small accounts are more
likely to lose money than large accounts.
45
This
may be because small accounts cannot afford the
minor pullbacks that are a normal part of trading.
Their stop losses are set so tightly that they are
triggered by the slightest downward movement.
It may also be because small investors want to get
big fast. They are attracted to the possibility of large
gains from leveraging. But they forget they can get
equally large losses. A string of wins can be wiped
out by one loss. And a string of losses is common.
Even professional traders may have three or four
losses in a row. Larger accounts are better able to
handle that series of losses and keep going.
45
The staff at DailyFX.com, ‘How the Best FX Traders Use Leverage’, The Money Show 28 Oct 2015 https://www.moneyshow.com/articles/
Leverage
Margin needed to
Control $100,000
% Change in
Account
100:1 $1,000 +/-100%
50:1 $2,000 +/-50%
33:1 $3,000 +/-33%
20:1 $5,000 +/-20%
10:1 $10,000 +/-10%
5:1 $20,000 +/-5%
3:1 $33,000 +/-3%
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Margin is the amount of money you need to
contribute to control the asset. The good news
is that you are in control. You get to determine
the amount of risk and the amount of loss you
are willing to take. Professional traders actually
determine their trade based on what they are
willing to lose. Since many traders want to keep
their risk on each trade to 1%-3%, they keep their
margins lower as well. It’s vital to preserve your
capital, or else you’ll soon have no money to trade
with.
How to Determine My Leverage? The leverage
is considered across your whole account, not
just on one trade. It’s easy to figure out. What is
your total position size including cash, assets, and
positions in your account? How much equity is in
your account?
Suppose you have £10,000 in your account. You’ve
used that to take positions in some currencies:
• 10,000 short EUR/USD
• 30,000 long CAD/USD
• 20,000 short JPY/GBP
Your total position size is £60,000 and your asset
size is £10,000. The formula is:
Total position size/ Account equity =Account
effective leverage
So your leverage would be: £60,000 divided by
£10,000 = 6 or a leverage of 6x
When you want to place a new trade, you may
wonder what size trade to take. When you know
the amount of leverage you want to use and the
equity in your account, it makes it easy. Remember
you want to take into account the TOTAL leverage
of all your positions. If some have lost value since
you put them on, you need to recalculate the
effective leverage on that trade.
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To find your trade size, multiply the unleveraged
equity in the account by your chosen leverage.
That will tell you what size position you can take
on your trade. The formula would look like:
Unleveraged equity x Leverage size = Maximum
trade size
So if you have €1,000 and you choose 3x leverage,
your maximum trade size would be €3,000.
Leverage and Risk: Because so many new traders
don’t fully factor in the risks of leverage, let’s take an
example of how leverage can affect your portfolio.
It’s just as easy to have a series of losing trades as
it is to have winning trades. Say you start trading
with $5,000.
First trade: 25,000 EUR/USD and it drops 2% -
$500. Your 5x leveraged loss: $2,500. You now
have $2,500.
Second trade: 25,000 EUR/JPY and it drops 1%.
And your trade loss is $250. But you have a
smaller amount of assets in your account So now
your leverage is 10x. And so your loss is -$2,250
and you’ve just lost 100% of your equity.
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Most trading platforms help you control your
risk. Platforms trading CFDs will stop your trades
when your account falls to zero. Provided there
is no slippage, you should not fall into a negative
balance.
Stock accounts have margin limits. An investor
might be able to borrow money from the brokerage
firm for leverage, but the brokerage determines
that equity backing the loan can’t fall below 25%.
Say you start with 2x leverage: you buy $10,000
of XYZ stock with your $5,000 in equity. Over the
next week, XYZ drops in value to $6,000. Now the
broker’s $5,000 loan is only backed by $1,000 of
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Wagner, Jeremy, ‘FOREX: How to Determine Appropriate Effective Leverage’, Daily FX, 10 Jan 2012 https://www.dailyfx.com/forex/education/
149
equity. That’s only a 20% margin. When the equity
backing the loan falls below 25%, the broker can
issue a margin call. That means you either need to
add money to your account or sell stock in order
to get your account margin back up.
If you don’t do that promptly, the broker will sell
stock to cover the margin call without letting you
know. This can lock in further losses. When you buy
the stock, as opposed to a CFD, only the margin
on the leveraged stock is taken into account in
determining the margin.
Slippage: Your stop loss setting or brokerage
order doesn’t guarantee the asset will be sold at
that price. The difference between the desired
sell price and the actual price at which your trade
is executed is called slippage. In a fast moving
market, this amount may be considerable. Flash
crashes are notorious for triggering sell orders that
execute far below the stop loss price.
Suppose you enter a Bitcoin trade at $2600. You
place a protective stop loss at $2500. A sudden new
event drops Bitcoin price to $2200 in a matter of
minutes. The platform enters your selling trade the
moment the price moves to $2500. But there are
no buyers there. The buyers have already lowered
their price. The sale may be made at $2300 or
even lower. If you use limit orders, the trade will
not execute until that price or better. But then you
risk not selling at all and taking steeper losses.
Comparing Leverage: Understanding the risks
of leverage will help you make better decisions as
you use it. Here is a chart showing the power of
leverage by comparing two traders using different
leverage. Call them William and Ben. Ben’s loss
allows him to move on to new trades. William’s loss
seriously impacted his portfolio.
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Wagner, Jeremy, ‘FOREX: How to Determine Appropriate Effective Leverage’, Daily FX, 10 Jan 2012 https://www.dailyfx.com/forex/education/
150
You can better manage your risks by:
• Using low levels of leverage
• Using trailing stops to protect your capital
• Practising your trading strategy until it works in
all situations
• Setting up the trade according to the amount you
are willing to lose
Limiting your capital to 1% or 2% per trade on
each position
• Stop trading for the day if your emotions are
getting in the way
Novice traders get excited about the leverage
possibilities with CFDs, but only when they are
winning. If they use leverage unwisely, they may
drop out of investing before they learn enough.
So get educated. Start with no leverage. Get your
strategy to the point that the winning trades
outnumber the losing ones. Make sure the amount
of money from the wins is much greater than the
loss in losing trades and then leverage can help
you work toward larger gains. Always be sure you
are trading within your means.
William Bent
Total Equity in
Account
£10,000 £10,000
Trade Size
Buys 50,
10K lots for
£500,000
Buys 5,
10K lots for
£50,000
Leverage 50:1 (50 times) 5:1 (5 times)
100 Pip Loss -£5,000 -£500
% Equity Loss 50.0% 5.0%
% Equity Left 50.0% 95.0%
Your capital is at risk. Cryptocurrencies can uctuate widely in prices and are therefore not appropriate for all investors. Trading cryptocurrencies is
not supervised by any EU regulatory framework. Past performance does not guarantee future results. This information is for educational purposes
and not investment advice.
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