A contract for difference (CFD) is derivative implying an agreement between a buyer and seller to exchange the price difference of a stock, bond, commodity or other asset between the dates that the contract is open and closed. If the price is higher at the close date, the buyer profits. If the price is higher at the open date, the seller profits.
CFDs are not available in the U.S. to retail investors because of Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) regulations. However, they are widely available in the U.K., Europe, and Asia. Learn about how CFDs work, and what similar derivatives are available here in the U.S.
Definition and Examples of Contracts for Difference
There are always two parties to a CFD, a "long position" (the buyer) and a "short position" is (the seller). CFDs are offered by brokers who may act as one of the two parties. CFDs are different from options and futures available in the U.S. because there is no expiration date, there is no standard contract size, and contracts are individually negotiated.
CFDs are a tool for traders to speculate on the short-term price direction of thousands of financial instruments and money managers to hedge their portfolio positions. CFDs are leveraged derivatives which means investors only need to deposit 3.3%-50% of the trade value depending on the contract. The CFD broker loans the balance to the investor at interest.
Leveraged derivatives magnify both gains and losses. These strategies are best left to savvy investors who understand the risks they entail.
CFDs are available for:
- Global financial indices
Spread bets are similar to CFDs. They're leveraged derivatives, and a speculation tool for traders. The key difference between the two is that spread betting has an expiration date and CFDs do not, in most cases. Spread betting is popular in the U.K. because the tax treatment is more favorable than CFDs.
How a CFD Works
CFDs are traded in units equal to the "ask" or "bid" price of the financial instrument used, depending on the trade. Bid price is the price you sell. For example, opening a $10,000 CFD buy trade for the fictional ABC company would look like this:
|Symbol||Last Price||Bid Price||Ask Price|
The investor would purchase 1,000 CFDs at the ask price of $10.00 to open a $10,000 CFD buy or "long" trade because they believe the price is going to rise. The margin rate set by the CFD broker is 5%, so the investor deposits $500. The CFD broker lends the investor the balance of $9,500.
If our bullish investor is right, and one week later the ABC bid rises to $10.50, the position is now worth $10,500. The loan is repaid to the CFD broker and the investor's profit looks like this:
|Value Of ABC Units||Margin Loan||Investor Deposit||Profit|
The investor profits $ 500 on their deposit of $500—a 100% return.
What if the investor thinks ABC stock is on it's way down? The bearish investor could open a sell or "short" trade. One-thousand CFD units would trade at the "bid" of $9.95 for a total of $9,950. In a short trade, the investor deposits 5% or $497.50, and the account is credited with the full value of the trade, or $9,950. If the bearish investor is right, and one week later the ask price of ABC is $9.45, it looks like this:
|Value Short Account||Value Of ABC Units||Profit|
A profit of $500 is a more than 100% return on the deposit of $497.50.
If our bullish investor was wrong about ABC and the bid price falls to $9.00, the loss is $1,000 on a $500 deposit.
|Value Of ABC Units||Margin Loan||Investor Deposit||Loss|
CFDs are not available in the U.S. to retail investors because they do not trade on an exchange, and there are no standard contracts, pricing, commissions, or trading rules. CFDs are, however, used by institutional investors like hedge funds and family offices.
Leverage Alternatives to CFDs for Retail Investors
Other leverage instruments are available in the U.S. to retail investors.
|CFD||Options||Margin Accounts||Leveraged ETFs|
|Available in the U.S.||No||Yes||Yes||Yes|
|Margin Rates||3.3%-50%||Margin account rates||Generally 50%||Margin account rate|
|Short Selling||Yes||Yes||Yes||Inverse ETFs|
|Cost||Commissions, interest, fees||Commissions||Interest||Commissions, fees|
What It Means for Individual Investors
While CFDs are not available in the U.S. to retail investors, CFDs, swaps and other highly leveraged derivatives are used by institutional investors. These large bets can go horribly wrong as they did in 2008. When they do, small investors can get caught up in the damage.
The Dodd-Frank financial reforms of 2010 took aim at regulating institutional investors’ use of swaps, CFDs, and similar instruments.
Nonetheless, the 2021 meltdown of Archegos Capital illustrates how leveraged derivatives can still pose a threat to the markets and small investors. Archegos Capital is a family office, which means that it is a money management firm owned by one individual—in this case, billionaire trader Bill Hwang—or family and manages only its money,. Family offices are exempt from the Investment Advisers Act of 1940, and the rules governing money management firms
According to a Bloomberg report, Archegos capital negotiated swaps and CFDs for billions of dollars, making highly leveraged bets on Viacom and other stocks with investment banks such as Morgan Stanley, Credit Suisse, Nomura and Goldman Sachs. Those bets went awry when those stocks saw a sell-off in March 2021, and Archegos did not have enough cash to meet the margin requirements. The investment banks, reportedly, arranged to sell off large holdings of Archegos, including Viacom to raise cash. These large trades, known as block trades, further drove down the price of Viacom, and other stocks.
After the dust settled, Archegos and Bill Hwang reportedly lost $20 billion. The investment banks too reported big losses–Morgan Stanley $900 million, Credit Suisse CHF 4.4 billion (approximately $4.7 billion), and Nomura approximately $2 billion. Retail investors and funds holding Viacom (VIAC) also bore the brunt of the stock's decline.
- Contract for Difference or “CFDs” are highly leveraged derivatives typically used by institutional investors
- CFDs are not available to retail investors in the U.S.
- CFD bets gone awry can cause ripple effects in the broader markets
- Retail investors in the U.S. can leverage their money using other instruments like options and leveraged ETFs.