CFDs are financial transactions that aim to generate profits from differences between buying and selling prices by using price movements in stock indices, stocks, gold, crude oil, and other assets.
With CFDs, rather than actually purchasing the underlying stocks or commodities themselves, the basic mechanism is a “contract for difference,” in which the difference between the price at which the trade was opened and the price at which it was closed is received or paid.
In addition, as with FX, leveraged trading using margin is possible, and some products allow trades to be opened not only by buying but also by selling.
On the other hand, while leverage allows large amounts to be traded with a small amount of funds, losses may also become large if the price moves in the opposite direction from what was expected.
In addition, if a CFD is held until the next business day or later, depending on the product, holding costs or adjustments such as overnight interest or price adjustment amounts may arise.
This article organizes the basics of what CFDs are, the differences from FX, stock index CFDs, commodity CFDs, overnight interest, leverage, and forced liquidation as a foundation for learning about asset management.
Note:
This article is a personal study note for learning about CFDs and asset management. It does not recommend any particular CFD product, securities company, financial product, trading method, or the like. Leverage, required margin, trading hours, spreads, overnight interest, price adjustment amounts, forced liquidation conditions, and other factors differ depending on the underlying product and provider and may be changed. When actually trading, check the latest information published by the Financial Services Agency, each provider, and other relevant organizations.
- What Is a CFD?
- CFDs Are Not Transactions in Which the Physical Asset Is Purchased
- With CFDs, You Can Trade from Both the “Buy” and “Sell” Sides
- There Are Various Types of CFDs
- Differences from FX
- Comparison of FX and CFDs
- FX Swap Points and CFD Overnight Interest Are Not the Same
- What Is a Stock Index CFD?
- What Is an Individual Stock CFD?
- What Is a Commodity CFD?
- Price Movements Can Be Large in Commodity CFDs
- What Is Overnight Interest?
- What Is a Price Adjustment Amount?
- What Is Leverage in CFDs?
- Leverage Differs Depending on the Underlying Asset in CFDs
- The Higher the Leverage, the Larger the Profits and Losses
- What Is Forced Liquidation in CFDs?
- What Is the Spread in CFDs?
- Main Factors Related to CFD Profits and Losses
- Be Aware of Holding Costs When Holding for the Long Term
- Differences Between CFDs and Cash Stocks
- Items to Check When Trading CFDs
- CFDs Also Have Risks
- CFDs and FX Are Similar but Are Not the Same
- Summary
- References
What Is a CFD?
CFD is an abbreviation for Contract for Difference and is generally referred to in Japanese as “difference settlement trading.”
With CFDs, transactions are conducted by referring to the prices of various assets such as stock indices, stocks, gold, silver, and crude oil.
Rather than purchasing and holding the underlying asset itself, profits and losses are basically calculated from the difference between the price at the start of the trade and the price at settlement.
Example:
If a CFD is bought at ¥10,000 and later settled at ¥11,000, the profit is ¥1,000 per unit in a simplified example.
Conversely, if it is settled after falling to ¥9,000, the loss is ¥1,000 per unit.
CFDs Are Not Transactions in Which the Physical Asset Is Purchased
A major characteristic of CFDs is that the referenced asset itself is not actually purchased.
Example:
Even if you buy a CFD linked to gold, you do not purchase gold bullion itself and hold it at home or in a storage facility.
Likewise, when trading a stock index CFD such as one linked to the Nikkei Stock Average, you do not actually purchase all of the stocks that make up the index.
It is strictly a transaction in which differences are settled based on movements in the underlying price.
With CFDs, You Can Trade from Both the “Buy” and “Sell” Sides
With CFDs, if you expect the price to rise, you can begin a trade by buying, and if you expect the price to fall, you can begin a trade by selling.
Buy Example:
If you buy at ¥10,000 and settle after the price rises to ¥11,000, the price difference becomes a profit in a simplified example.
Sell Example:
If you begin a trade by selling at ¥10,000 and buy it back after the price falls to ¥9,000, the price difference becomes a profit in a simplified example.
However, if the price moves in the opposite direction from what was expected, a loss occurs.
There Are Various Types of CFDs
CFDs are divided into various types depending on what they reference.
- Stock index CFDs
- Individual stock CFDs
- Commodity CFDs
- CFDs that reference bonds
- CFDs that reference other financial products
The types of products available differ depending on the CFD provider.
Differences from FX
FX and CFDs are both transactions in which margin is used and differences are settled, and their mechanisms have some similarities.
The major difference is mainly what type of price is being traded.
In FX, exchange ratios between two currencies, such as USD/JPY and EUR/USD, are traded.
With CFDs, you can trade by referring to the prices of various non-currency assets such as stock indices, stocks, gold, and crude oil.
Comparison of FX and CFDs
| Item | FX | CFD |
|---|---|---|
| Main Trading Assets | Currencies | Stock indices, stocks, commodities, etc. |
| Basic Transaction | Difference settlement | Difference settlement |
| Margin | Used | Used |
| Leverage | Available | Available |
| Trading from the Buy Side | Possible | Possible |
| Trading from the Sell Side | Possible | Possible |
| Main Adjustments While Holding | Swap points | Interest adjustments, price adjustments, etc. |
| Forced Liquidation | Yes | Yes |
FX Swap Points and CFD Overnight Interest Are Not the Same
In FX, swap points are received or paid based on factors such as the interest rate differential between two currencies.
With CFDs, depending on the product, interest adjustments may arise when a position is held until the next business day or later.
In both cases, amounts may be received or paid as a result of holding positions, but the calculation mechanisms are not the same.
What Is a Stock Index CFD?
A stock index CFD is a CFD traded by referring to movements in major stock indices such as the Nikkei Stock Average and major U.S. stock indices.
Because a stock index is calculated based on the stock prices of multiple companies, it is possible to trade the movements of an entire market or a specific market rather than those of an individual company.
Example:
If you believe that the overall Japanese stock market will rise, one possible trade is to buy a CFD that references a major Japanese stock index.
Conversely, if you believe that the overall stock market will fall, you can also begin a trade by selling.
With Stock Index CFDs, You Do Not Need to Select Individual Stocks
When trading individual stocks, it is necessary to check each company’s business performance, financial results, financial condition, and other factors.
With stock index CFDs, the movement of the entire index rather than that of a specific company is traded, so their characteristics differ from transactions whose price movements are affected by only one company.
However, if the overall market falls sharply, stock index CFDs may also decline significantly.
Main Factors That Move Stock Index CFD Prices
Various factors affect the prices of stock index CFDs.
- Corporate performance
- Economic conditions
- Policy interest rates
- Inflation rates
- Economic indicators such as employment statistics
- Foreign exchange rates
- Political conditions
- War and geopolitical risks
- Investor expectations and concerns
What Is an Individual Stock CFD?
An individual stock CFD is a CFD traded by referring to the stock price of a specific company.
Unlike ordinary cash stock investing, you do not hold the stock itself, but settle the difference resulting from changes in the stock price.
Therefore, even if you trade a company’s stock price through a CFD, you do not have the same rights as a shareholder who owns ordinary cash shares.
What Is a Commodity CFD?
A commodity CFD is a CFD traded by referring to commodity prices such as gold, silver, and crude oil.
The available products differ depending on the provider, but representative underlying assets include the following.
- Gold
- Silver
- Crude oil
- Natural gas
- Other commodities
What Is a Gold CFD?
With a gold CFD, profits and losses arise from increases and decreases in the price of gold.
Because gold bullion itself is not purchased, there is no need to prepare a place to store the physical asset.
On the other hand, because it is a CFD, it is a margin transaction, so leverage, forced liquidation, and other factors must be considered.
What Is a Crude Oil CFD?
With a crude oil CFD, trades are conducted by referring to movements in crude oil prices.
Crude oil prices may fluctuate significantly not only because of the global economy, but also because of production volumes in oil-producing countries, inventories, demand, geopolitical risks, and other factors.
- Growth and slowdown of the global economy
- Demand for crude oil
- Increases and decreases in production by oil-producing countries
- Crude oil inventories
- Wars and conflicts
- Foreign exchange rates
Price Movements Can Be Large in Commodity CFDs
Commodity prices may fluctuate significantly over short periods because of supply and demand, political conditions, weather, disasters, and other factors.
When leverage is used, large movements in commodity prices may also cause large profits or losses relative to your own funds.
What Is Overnight Interest?
With CFDs, when a position is held until the next business day or later, interest adjustments and other amounts may arise depending on the product.
Interest related to carrying a position in this way is sometimes generally referred to as overnight interest.
Because CFDs are transactions in which margin is used to hold positions of large value, interest adjustments may be made based on funding costs and other factors related to maintaining the position.
Concept:
Even if a CFD position worth ¥1 million is held with ¥200,000 in margin, the position being traded itself is still worth ¥1 million.
If the position is carried over to the next day or later, interest adjustments and other amounts related to holding that position may arise.
Overnight Interest Differs Depending on the Product
Overnight interest is not generated in the same way for all CFDs.
The adjustment method may differ depending on how the CFD price is formed and whether the product references spot prices or futures prices.
In addition, the direction and amount of payments and receipts may differ between buy positions and sell positions.
What Is a Price Adjustment Amount?
Some CFDs are priced by referring to futures prices and other prices.
Because futures have expiration dates, when the referenced futures contract is switched to the next contract month, a price adjustment amount or similar adjustment may arise in order to adjust for the difference between the old and new futures prices.
The specific name and calculation method differ depending on the CFD provider and product.
What Is Leverage in CFDs?
With CFDs, by depositing margin, you can trade an amount larger than your own funds.
This mechanism is called leverage.
Example:
If you have ¥1 million in funds and are trading ¥1 million worth of CFDs, the leverage is 1x in a simplified calculation.
If you have ¥1 million in funds and are trading ¥5 million worth, the leverage is 5x in a simplified calculation.
Leverage Differs Depending on the Underlying Asset in CFDs
With CFDs, the required margin ratio may differ depending on the underlying asset being traded.
In retail securities CFDs in Japan, the margin ratios differ even between individual stocks and stock indices.
In addition, trading conditions for commodity CFDs and other products differ depending on the product and provider, so it is necessary to check the required margin for the product actually being traded.
The Higher the Leverage, the Larger the Profits and Losses
Using leverage allows you to hold a large position with a small amount of your own funds.
However, the higher the leverage, the larger the profits and losses relative to your own funds for the same price movement.
Example:
If a ¥1 million position moves by 1%, the profit or loss is approximately ¥10,000 in a simplified calculation.
If a ¥5 million position moves by 1%, the profit or loss is approximately ¥50,000 in a simplified calculation.
If your own funds are ¥1 million in both cases, the latter is more strongly affected by price movements relative to your own funds.
What Is Forced Liquidation in CFDs?
With CFDs, if the price moves in the opposite direction from what was expected, unrealized losses increase, and the margin situation deteriorates to a certain level set by the provider, the position may be forcibly closed.
This mechanism is called forced liquidation.
Concept:
If the price falls significantly while you are holding a CFD buy position, unrealized losses increase.
As a result, if the available margin falls to the level set by the provider, the position may be forcibly closed.
Even with Forced Liquidation, the Amount of Loss Is Not Guaranteed
Forced liquidation is a mechanism designed to limit the expansion of losses.
However, if the market moves sharply or market liquidity declines, it may not be possible to settle at the expected price.
As a result, losses may expand beyond the forced liquidation level.
What Is the Spread in CFDs?
With CFDs, there may be a difference between the buying price and selling price.
This difference is called the spread and is one of the effective trading costs.
The spread may change depending on the product and market conditions.
When the market is moving sharply or liquidity is declining, the spread may widen.
Main Factors Related to CFD Profits and Losses
When considering CFD profits and losses, it is necessary to check not only simple price movements but also the following factors.
- Price movements of the underlying product
- Trade size
- Leverage
- Spread
- Interest adjustments
- Price adjustments
- Other adjustment amounts
- Required margin
- Forced liquidation conditions
Be Aware of Holding Costs When Holding for the Long Term
CFDs can be used not only to take advantage of short-term price movements, but also to hold positions for long periods.
However, when positions are held for long periods, interest adjustments and other costs may accumulate.
Even if the price itself changes very little, profits and losses may change because of holding costs.
Therefore, when holding CFDs for the long term, it is necessary to check not only price movements but also the adjustment amounts that arise during the holding period.
Differences Between CFDs and Cash Stocks
| Item | CFD | Cash Stocks |
|---|---|---|
| Trading Mechanism | Difference settlement | Purchase of the shares themselves |
| Do You Become a Shareholder? | Normally no | Yes |
| Leverage | Available | Not used in ordinary cash trading |
| Trading from the Sell Side | Possible | Basically not possible in ordinary cash trading |
| Forced Liquidation | Yes | Normally none |
| Holding Costs | Interest adjustments and other costs may arise | There are normally no interest adjustments simply from holding the shares |
Items to Check When Trading CFDs
When trading CFDs, it is important to check not only the price of the underlying asset but also the trading conditions of the product.
- What the CFD references
- Current price
- Trading unit
- Required margin
- Leverage
- Spread
- Trading hours
- Interest adjustments
- Price adjustments
- Forced liquidation conditions
- Conditions for buy and sell positions
- The market or product being referenced
CFDs Also Have Risks
While CFDs offer the possibility of earning profits from price movements in stock indices, commodities, and other assets, they also involve various risks.
- Price fluctuation risk
- Expansion of losses due to leverage
- Forced liquidation
- Slippage during sudden market movements
- Widening spreads
- Holding costs such as interest adjustments
- Liquidity risk
- Commodity-specific supply and demand fluctuations in commodity CFDs
- Risks specific to overseas markets when referencing overseas markets
CFDs and FX Are Similar but Are Not the Same
FX and CFDs are very similar in that margin is used for leveraged trading and profits and losses arise from price differences.
However, while FX involves trading currencies, CFDs allow a broader range of underlying assets such as stock indices, stocks, and commodities to be traded.
In addition, swap points are an important factor in FX, while CFDs may involve interest adjustments, price adjustments, and other amounts depending on the product.
Therefore, rather than trading CFDs with exactly the same understanding as FX, it is important to check the mechanism of each underlying product.
Summary
CFD is an abbreviation for Contract for Difference and is a financial transaction in which price movements in stock indices, stocks, gold, crude oil, and other assets are referenced and profits and losses are settled based on the difference between the price at the start of the trade and the price at settlement.
As with FX, leveraged trading using margin is possible, and trades can be started not only by buying but also by selling.
While FX uses currencies as the trading target, CFDs can use the prices of a wide range of assets such as stock indices, individual stocks, gold, and crude oil as trading targets.
With stock index CFDs, it is possible to trade based on movements in the overall stock market rather than those of individual companies.
With commodity CFDs, profits and losses arise from increases and decreases in the prices of commodities such as gold and crude oil.
In addition, with CFDs, holding a position until the next business day or later may result in interest adjustments and other amounts.
Because CFDs allow leverage to be used, large positions can be held with a small amount of funds, but losses caused by price movements may also become larger as a result.
If losses increase and the margin situation deteriorates to a certain level, the position may be forcibly closed through forced liquidation.
When considering CFDs, rather than looking only at whether “the price will rise or fall,” it is important to check a combination of factors such as the underlying asset, leverage, required margin, spread, interest adjustments, price adjustments, trading hours, and forced liquidation conditions.
References
