Contract for Difference (CFD)

A contract for difference (CFD) is a derivative contract between a trader and a provider, usually a broker, in which the two agree to exchange the difference in the price of an asset between the time the position is opened and the time it is closed. If the price moves in the trader's favour, the provider pays the difference; if it moves against them, the trader pays. The trader never owns the underlying share, index, currency, commodity or cryptocurrency, and can bet on prices falling as easily as rising.

CFDs are traded over the counter rather than on an exchange and are offered mainly to retail traders, with high leverage. They are popular in the UK, Europe, Australia and parts of Asia but are not available to retail investors in the United States, where such products fall under swaps rules. Regulators in many countries have restricted them because most retail clients lose money.

Imagine making a deal with a friend about the price of a share without either of you buying it. You say it will go up; your friend agrees to pay you the rise if it does, and you agree to pay them the fall if it does not. You each put down only a small deposit to show good faith.

A CFD is exactly that kind of deal, made with a broker instead of a friend. Because you put down only a deposit, a small price move can mean a big gain or loss compared with the money you put in. And because the broker often takes the other side, it is in your interest to understand how it makes money and what happens if prices jump suddenly.

A trader opens a CFD by choosing a number of units and a direction, buying (going long) if they expect a rise or selling (going short) if they expect a fall. The provider requires a margin deposit, a percentage of the position's value. The profit or loss, before costs, is:

• $P_{\text{close}}$ is the price at which the position is closed.
• $P_{\text{open}}$ is the price at which it was opened.
• $N$ is the number of units, negative for a short position.

For example, a trader buys a CFD on 100 shares at $50, a position worth $5,000, with a 20% margin requirement, putting up $1,000. If the price rises to $54, the profit is (54 − 50) × 100 = $400, a 40% return on the margin. If it falls to $46, the loss is $400, also 40% of the margin. Costs include the bid-ask spread, any commission and overnight financing charges for positions held past the end of each trading day. Long share CFDs usually receive an adjustment equal to dividends paid, while short positions pay it.

CFDs are generally traced to London in the early 1990s, when they were used by institutional investors and hedge funds to take leveraged positions in shares while avoiding UK stamp duty, a tax on share purchases. Online brokers began offering them to retail clients in the late 1990s and 2000s, and they spread to other financial centres, extending to indices, currencies, commodities and, later, cryptocurrencies.

In 2018, the European Securities and Markets Authority imposed restrictions on CFDs sold to retail clients, later adopted permanently by national regulators including the UK's Financial Conduct Authority. They include:

• Leverage caps. Limits ranging from 30:1 for major currency pairs to 2:1 for cryptocurrencies.
• Margin close-out. Positions must be closed when account equity falls to half the required margin.
• Negative balance protection. Retail clients cannot lose more than the money in their account.
• Risk warnings. Providers must state the percentage of their retail accounts that lose money, which is typically a large majority.

The FCA has banned the sale of crypto CFDs and other crypto derivatives to UK retail consumers since January 2021. Australia's securities regulator introduced similar product intervention rules in 2021.

The main risk is leverage: small adverse moves can wipe out a trader's margin, and gaps in price can cause losses beyond the level of a stop-loss order. Traders also face counterparty risk, since the contract is only as good as the provider, and conflicts of interest where the broker profits from clients' losses. Critics argue that CFDs are closer to betting than investing for many retail users, and that aggressive marketing has drawn in inexperienced traders. Supporters note that CFDs allow cheap short selling and hedging, and that well-regulated providers now offer stronger protections. Related products are discussed under Margin Trading and Derivatives.