Understanding the History of CFDs Trading

Understanding the History of CFDs Trading

Reading Time: 12 Minutes

Given their wide adoption, CFDs (Contracts for Differences) may seem like the industry standard nowadays, but it wasn’t always that way.

In the history of financial markets, CFDs are a relatively new addition that has helped shape how investors trade. This post aims to dive into the origins of CFDs and explore how they’ve transformed the trading landscape, examining key milestones that have driven their adoption across the globe.

What is CFD Trading?

CFDs are a popular financial derivative product, allowing investors to speculate on global markets’ rising or falling prices. With CFD trading, rather than owning the underlying asset (like in physical share dealing in the stock market), market participants buy or sell units (or trading lots) to trade based on a particular financial instrument’s underlying price, depending on whether they believe its value will go up or down.

CFDs are essentially agreements (contracts) made between two parties to exchange the difference in the price of a financial instrument from when the contract is opened until it is closed. If a trader believes an instrument's price will increase, they take a 'long' position (buy); if they believe the price will decrease, they take a 'short' position (sell). The profit or loss is determined by the difference in price from when the position is opened to when it is closed, multiplied by the number of units (or lots) held.

Functionally, CFDs are similar to owning the asset outright; traders can generate returns or losses by speculating on the asset’s underlying price movements. However, some key features of CFDs make them distinct from other financial instruments.

Leverage

CFDs are leveraged products, meaning traders can gain exposure to a larger position without committing the full cost upfront. Leverage is expressed as a ratio (e.g., 30:1), representing the amount a trader can multiply their initial investment (their account equity). However, while leverage amplifies potential returns, it can equally amplify losses, so when trading CFDs, or any financial asset class for that matter, it is important to adopt a robust risk management system.

Margin

Margin, or initial margin, is the amount of capital a trader needs to deposit for collateral with their broker to execute a leveraged position. The margin percentage is the amount of the notional value that must be deposited. For example, in Forex, this is simply calculated by dividing the leverage ratio. So, if your trading account’s leverage is set to 100:1, divide 1/100 to get 0.01, or 1% - your margin percentage rate given the associated leverage ratio.

Margin requirements vary depending on the financial instrument, the broker, and the trader's experience level.

Long and Short Positions

CFD traders can profit from both rising and falling markets by taking long or short positions. When closing a position, traders either buy back the short or sell the long, realising a profit or loss based on the price movement. There are a number of order types that help streamline your trading, such as market orders, limit (or pending) orders and trailing stops, for example.

Development of CFD Trading

CFD markets can be traced back to the early 1990s in London, where they were initially developed for hedge funds and institutional investors to gain exposure to financial markets without having to pay stamp duty or post significant margins. The idea is credited to Brian Keelan and Jon Wood, who worked at UBS Warburg at the time.

Retail Interest Picks Up

Between 2000 and 2001, it became clear to retail investors and traders that CFDs provided tax advantages and the opportunity to leverage various financial instruments. Offerings soon expanded to include indices, global stocks, currencies, and commodities.

Based on major global indexes like the Dow Jones Industrial Index in the US, Hong Kong’s Hang Seng, and Japan’s Nikkei 225, Index CFDs gained immense popularity and remain favourable today.

Overseas Expansion

The mid-2000s saw significant growth in CFD trading, driven by increased marketing efforts from brokers, more sophisticated trading platforms, and a greater understanding of the benefits and risks associated with this form of trading. CFD providers expanded into international markets, with Australia being the most notable example.

UK-based CFD brokers were the first to reach Australia, leading to a surge in retail interest. Traders could now access a wide range of Australian stocks with 20:1 leverage - something unheard of then. During this period, CFDs were introduced into dozens of other countries and jurisdictions, including the Eurozone, Canada, Singapore, South Africa, and New Zealand.

However, CFD trading remains restricted for retail traders in the United States. The Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) have stated that CFDs are unsuitable for the US market, prohibiting them from being listed on US-based exchanges.

Benefits and Risks of CFD Trading

CFDs clearly do have advantages over other types of instruments. However, it’s also important to consider some of their disadvantages. Let’s look at some of the key benefits and risks of CFD trading.

Benefits of CFD Trading

• Leverage: Leverage allows traders to control larger positions with less initial capital. This means potential profits can be magnified, but losses are also amplified.
• Long or Short: CFDs traders can trade both rising and falling markets. This provides more flexibility than purchasing an asset outright since short selling can be more complex in other markets, like physical share trading.
• Wide Access to Global Markets: CFD brokers often offer access to a wide range of global markets, including stocks, indices, commodities, and currencies. This allows traders to exploit opportunities in different market sectors and regions through one brokerage.
• Hedging Opportunity: Traders can use CFDs as a hedging tool to help protect their existing positions. By taking a short position in a CFD, when long the underlier, traders can offset potential losses in their underlying investments if the market moves against them.

Risks of CFD Trading

• Leverage Risk: While leverage can boost potential profits, it can also amplify losses. If the market moves against a trader's position, losses can quickly accumulate, potentially leading to significant losses or even account liquidation.
• Overnight Fees: When holding leveraged CFD positions overnight, traders may be subject to financing charges, also known as a swap charge at rollover. These fees can add up over time and may be proportional to the number of days the position is held.
• Overtrading: The ease of trading and low margin requirements in CFD trading can lead to overtrading, where traders take on too many positions or trade too frequently. This increases exposure to risk and can result in substantial losses.
• Lack of Ownership Rights: Since CFD traders do not own the underlying asset, they do not have the same rights as individuals who own it outright, such as voting rights. This means traders miss out on some of the benefits of holding the actual asset.

Choosing a CFD Trading Platform

While many platforms offer CFD trading, they’re not all created equal. In fact, there are several hallmarks of a quality CFD trading platform and CFD provider. Be sure to look for the following:

• User-Friendly Interface: The platform should be easy to navigate, with a clear layout and well-organised tools and features.
• Range of Tradeable Instruments: Look for platforms that offer a wide selection of CFDs, especially in your preferred markets.
• Competitive Pricing and Fees: The CFD provider should offer competitive spreads and low fees in general, with little or no account maintenance fees.
• Reliable Customer Support: A CFD provider with responsive and knowledgeable customer support that can help with any issues that arise.
• Security and Regulation: Ensure the CFD provider is well-regulated and employs strong security measures to protect your information and funds.

Interested in Trading CFDs?

FP Markets is the premier destination for CFD trading, offering access to over 10,000 tradeable instruments across four continents and over 70+ currency pairs, as well as a wide range of commodities, indices, individual shares, ETFs and digital currencies. As a globally-regulated and award-winning Forex and CFDs broker, FP Markets are committed to delivering exceptional service, competitive pricing, and cutting-edge technology.