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What you should know about trading CFDs

CFDs, or Contracts For Difference, are more popular than ever. Although launched already in the early 1990s, the biggest boom came in the recent few years. Due to tax-friendliness it holds a competitive advantage over shares and other instruments and therefore CFDs are in demand. On the offer side, specific regulations, directives (MIFID) and light supervising regimes (British FCA, Cyprus CySec) made it very interesting for financial intermediaries to offer this type of product.

Without going too much into details why the regulatory framework enabled CFDs to become really big, (private) investors should make note of a couple of essential market conditions. But first, let’s start with highlighting what CFDs actually are. This is necessary to understand the market functioning and more importantly, the success of your trades and strategy.

CFD = speculation on price movements

As the name describes, CFDs are products that make it possible to benefit from price movements. When we ‘purchase’ or ‘sell’ a CFD at any given moment, the result of the trade is measured from the distance to the original price. Purchase and sell is in brackets, since we do not actually trade a product. We close a contract, hence the C in CFD. That also means that no transaction on a stock exchange is required. This brings cost advantages, since stock exchange charge fees and also the settlement and clearing of instruments (so that you become the owner of the instrument) are not free of charge. These fees are most of the time brought together in a single transaction fee. Without the exchange recording a trade, no transaction fees.

There’s also a very important downside of CFDs not being traded on an exchange. Normally, when trading an instrument which is listed on an exchange, your broker or financial intermediary is only facilitating a transaction between two parties. But with a CFD, you close a contract with a counterparty. In fact, your broker or a related party will be the counterparty. As a result, your loss is the broker’s gain (and vice versa). Therefore, a potential conflict of interest may arise. In addition, the position bears far more (counterparty) risk, since not settled through a clearing company.

The latter problem is solved by maintaining margins. In exceptional cases, like we saw with the EURCHF, that is not enough to cover the risk. Therefore, prudent brokers will hedge risk. A bigger concern is the conflict of interest. You don’t want to initiate a trade in which the party responsible for execution, registering and safekeeping the position, will benefit from your loss. Nevertheless, that is exactly the way a number of CFD-operators function!

CFD Market Models

Fortunately, there are brokers that pursue a CFD-model without taking the other side. Investors should realize there are three models. However, all three have pros and cons.

  1. DMA-model: In this model, a CFD follows the underlying asset on a physical market. DMA stands for Direct Market Access. The broker will hedge the CFD on the underlying market, visible for the client. As a result, the position is less exposed to counterparty risk. Main advantage is that conflict of interest is safeguarded. The price development of the position is also transparent, since it tracks 1:1 the actual market. However, these CFD-transactions come with transaction costs, due to exchange fees etc. for the broker. Most of the time, especially with larger orders these costs are negligible compared to the usual wider spreads maintained by other CFD-models.

  2. Agency Broker Model: CFD-positions are also hedged, which lowers conflict of interest. However, the broker doesn’t necessarily pass through the orders on the exchange. The position doesn’t follow the underlying price 1:1, mark-ups or mark-downs or wider spreads are possible.

  3. Market Maker Model: The broker takes the order into its book and it is unclear whether the position will be hedged. That means the broker or a related party is on the other side of your trade and will benefit if you lose. Next to a conflict of interest, risks are high in the event of a ‘black swan’ if large positions are not hedged. The broker may not be able to cover losses and could go down, as we witnessed at one operator when the SNB ended the EURCHF-peg back in January 2015. Furthermore, the operator will likely use mark-ups or mark-downs and thus wider spreads. This will be most visible during events, such as publications of macro-economic data and company results. But also in periods of high volatility, unfavorable prices and spreads are likely, since it’s in the brokers interest that the clients position will be stopped out. Remember: your loss is the brokers gain here. Unfortunately, there are many CFD-providers who execute orders following the market maker model. This is perfectly legal, but obviously that doesn’t mean it’s investor-friendly…

Make certain your CFD broker is hedging

What does this all mean for us when trading in CFDs? First of all, we should check under which market model our broker operates. DMA-operators are most certainly open about their operating model, since the transparency, higher reliability and safety that comes with DMA is a clear competitive advantage. Also agency brokers will show that they hedge their positions and are not on the other side of your trade. Always make certain your broker is hedging the position in the market! There are pretty big names which operate under a market maker model. For instance, Plus 500 is known for taking the other side of the trade and only hedges if total exposure in an instrument reaches are certain threshold.

The DMA model is highly preferable, with the agency broker as a respectable second choice. You don’t want that the party which facilitates your trades, benefits from your misery, so once more, look for hedging by the operator. Also you want that your position follows the market fair and square. Transparency and fairness are key in trading. Nevertheless, this comes at a price, albeit small. DMA brokers require higher margins and charge commissions. With smaller accounts, some traders could be tempted to use market maker models. If so, a trader should make sure the prices that are offered follow the market and your executions are fair. Check your trades with the psychical market on a regular basis to verify that execution is fair. Remember: the operator benefits from trouble on your side, so you are on your own. Make sure you can verify (eventually prove) what the market is doing.

Also realize that softer i.e. smaller margin requirements compared to competitors means that the CFD-broker holds less buffer for losses. Thus, its operations are riskier.

If you choose for a market making CFD-operator, make sure your position sizing is relatively small. Don’t set your stop losses too tight and refrain from trading during events which likely have a large impact on price movement. Obviously this advice is also applicable on regular trading on other broker models, but here it is even more relevant.

Know with whom you’re dealing and always trade safe!