This is not investment advice. The information provided is for educational and informational purposes only and does not constitute a recommendation to buy or sell any financial product.
A Contract for Difference (CFD) is a contract with a broker that pays the difference between the entry price and the exit price of the underlying asset. A CFD on a stock pays the price move on the stock, without the trader owning the shares. CFDs are leveraged by default, and the leverage is set by the margin requirement. The role of leverage in a CFD is to make the position efficient, not to amplify the bet, and the trader who uses CFDs should understand the difference.
What a CFD actually is
A CFD is not a security. The trader does not own the underlying shares, and the trader does not have the right to vote or to receive dividends in the same form as the underlying. The CFD is a contract with the broker, and the broker is the counterparty. The contract is settled in cash, and the cash is the difference between the entry and the exit price, multiplied by the share count.
A CFD on a stock pays the price move on the stock, but the CFD does not give the trader the right to vote at the company's annual meeting, and the CFD does not give the trader the right to receive the dividend in cash. The dividend is usually credited to the CFD as a cash adjustment, but the adjustment is net of the broker's financing cost, and the net is usually lower than the underlying dividend.
A CFD is also subject to the broker's margin call and the broker's financing cost. The trader who holds a CFD overnight pays the financing cost on the borrowed portion, and the cost is a real drag on long-term holds. The trader who holds a CFD through a major corporate action (a stock split, a special dividend) is exposed to the broker's adjustment, and the adjustment may not match the underlying.
How leverage works in a CFD
A CFD is leveraged by the margin requirement. The trader puts up a fraction of the position value as a deposit, and the broker lends the rest. The trader's return is amplified by the leverage ratio.
The leverage ratio is set by the broker, the regulator, and the trader's account type. ESMA in the EU caps retail leverage on stock CFDs at 1:5, which is a 20% initial margin. Offshore brokers can offer higher leverage, but the regulatory protection is thinner.
The leverage ratio is also a function of the underlying's volatility. A volatile stock has a higher margin requirement than a less volatile stock, and the leverage ratio is lower.
The role of leverage in a CFD
The role of leverage in a CFD is to make the position efficient. A trader who wants to take a short-term view on a stock can use a CFD to size the position to the view, without committing the full notional in cash. The freed capital is the actual economic benefit of the leverage, and the trader can use the freed capital for another trade, a hedge, or cash.
The role is not to amplify the bet. A trader who uses leverage to take a position larger than the unleveraged position would have been is taking on risk that the trader does not need to take, and the trader is exposed to the asymmetric risk profile of leverage. The asymmetric risk profile is the result of the compounding of losses, and the compounding is most pronounced in fast markets.
The honest use of leverage in a CFD is to size the position to the stop and the account, not to the desired return. A trader who has a €10,000 account, a 1% risk per trade, and a stop 5% away from entry needs a position size that produces a €100 loss at the stop. The leverage figure is whatever the position size requires, not a goal in itself.
The costs of leverage in a CFD
The first cost is the financing cost. A CFD held overnight pays a financing rate on the borrowed portion. A 5% annual financing rate on a 5:1 leveraged CFD is roughly 20% per year on the trader's capital, paid daily. The cost is the most common reason that leveraged CFDs underperform the underlying over long horizons.
The second cost is the spread. A CFD has a spread between the bid price and the ask price, and the spread is the broker's compensation for providing liquidity. The spread is usually wider than the spread on the underlying stock. The trader pays the spread on every round-trip trade.
The third cost is the slippage. A CFD is filled at the broker's price, and the fill price can be different from the requested price. The slippage is small in a liquid market and large in a thin market. The trader should expect a small percentage of trades to have meaningful slippage.
When to use a CFD with leverage
A CFD with leverage is most appropriate for a short-term tactical position, where the trader has a directional view for a few days and wants to size the position to the view. The CFD allows the trader to take the position without committing the full notional, and the leverage is a tool for efficiency, not for amplification.
A CFD with leverage is also useful for hedging. A trader with a long portfolio can take a short CFD position to hedge a known risk window, and the cost of the hedge is the financing rate on the borrowed portion. The hedge is not free, but the hedge is cheaper than closing the long position and re-entering after the event.
A CFD with leverage is less appropriate for a long-term hold, where the trader is using the CFD as a substitute for owning the shares. The financing cost compounds over the hold period, the trader does not own the shares, and the trader is exposed to the broker's adjustments on corporate actions. The trader is better off buying the shares directly, with the right to vote and the right to receive dividends in the same form as the underlying.
Related resources
Where to start
If you are evaluating CFDs for your strategy, the most useful exercise is to fund a small account at a CFD broker and to test the platform for a week. Our broker comparison lists the CFD brokers, the leverage available, and the fee schedule, which together tell you what the cost and the workflow look like before you commit.