CFD trading: Laws and alternatives

If you’re a global investor or international trader, you may have heard of contracts for difference (CFD) trading. CFDs exist across most of the world and are especially popular in Europe and Australia — but they’re not allowed in a few places, most notably the United States and Hong Kong.

What is a CFD?

A contract for difference is an agreement based on an underlying asset or financial instrument, such as a stock, commodity or currency pair. The buyer of the contract believes the underlying asset will increase in value from the time the contract is initially opened to when it is closed, while the seller of the contract believes the underlying asset will decrease in value.

At no point do the contract buyers own or have an obligation to own the underlying asset itself, nor are they trading the underlying asset. Because they’re only trading a contract, CFD traders can profit regardless of whether prices are going up or down. For that reason, CFD trading often becomes more popular during times of market volatility, as traders seek to profit by “shorting” the market when it falls.

While CFDs can be profitable, they’re also highly risky, complex products that are suited to more experienced traders.

Why are CFDs illegal in the US?

There are CFDs on US stocks and US stock market indices, but US residents generally cannot open CFD trading accounts due to government regulations. CFDs are considered unregulated over-the-counter products because they can be traded by any two willing parties on any marketplace that allows them. They’re not listed on any regulated exchange, and the SEC and CFTC haven’t allowed them to be listed on any regulated exchange due to their high risks.

What are the risks?

CFDs are extremely risky products for the following reasons:

• Leveraged: Traders are only required to contribute a small portion of the money involved in each trade and can borrow the rest from the trading platform — sometimes as much as 30 times the amount invested. Borrowing money to invest is always a risky move.
• Unlimited: You can lose more money than you initially invest. Unlike most other investments, you can lose much more money than you started with, meaning you actually owe the CFD provider money.
• No collateral: You don’t own the underlying asset. All you own is the contract between you and the CFD provider. Therefore, you can’t benefit from the capital growth of the underlying asset over the long term.
• Volatile: Just like their underlying assets, CFDs are affected by market conditions and can swing wildly back and forth without notice in volatile markets.
• Illiquid: Depending on the trading volume of the CFD, there may not be a buyer or seller available when you want to close out your position.

Can I trade CFDs in overseas markets?

US regulators prohibit US residents from trading CFDs both within the country and outside the country, so most foreign CFD providers will not allow US residents to even open an account. Dual citizens may be able to open a CFD account if they’re not living in the US. And if a foreign provider did allow a US resident to open a CFD account, it would likely not be regulated in its home country, adding further risks to trading activity.

Alternatives to CFDs

There’s no legal investment that operates just like CFDs in the US, but there are some that have elements in common:

Leveraged ETFs

Some ETFs utilize riskier derivatives in order to multiply gains or losses in select stock indices and commodities. You can buy or sell these in a normal brokerage account without risking any more than you invest and without owning or being obligated to own the underlying asset. Leveraged ETFs are designed for short-term trades, not buy-and-hold investing. They’re regulated by the SEC just like stocks and bonds.

Options

These are also leveraged to multiply the moves of an underlying stock, stock market index or commodity, and there’s no collateral needed if you’re a buyer of a call or put option and you don’t exercise it. Plus, you can’t lose more money than you invest and options are accessible in most mainstream stock trading platforms. Like stocks and commodities, options are regulated by the SEC, FINRA and/or CFTC.

Binary options

A lesser-known cousin to regular options, binary options — like CFDs — are a derivative investment that never owns or has an obligation to own the underlying asset. They’re a yes-or-no contract based on the price movement of the underlying asset within a limited timeframe, and they typically operate on a scale of $0 to $100.

For example, say you buy a binary option on gold for the current week at the strike price of $1,700. If the current price is just below $1,700, you might be able to buy the binary option for $50, and if gold ends the week above $1,700, you receive $100 back; if gold ends the week below $1,700, you get nothing.

You can also sell to close the binary option at the market price. Nadex is the only US-regulated exchange that allows binary options trading, so you’d have to open an account there. It’s focused on currencies, commodities and a few global stock indices.

Futures contracts

Futures also involve lots of leverage, and you can lose more money than you invest. But the big difference compared to CFDs is that futures involve the underlying asset — you’re obligated to buy or sell the asset in question on the delivery date. Futures are regulated by the CFTC and traded in specialized brokerage accounts. Not all mainstream trading platforms support futures trading.

Forex

Like CFDs and futures, the foreign exchange market involves substantial leverage, and you can lose more money than you invest. Forex trading can involve the underlying currencies — as in forex forwards and futures — but there are also spot forex derivatives that don’t involve any collateral. It’s an over-the-counter investment, but it’s supervised by the NFA and CFTC.

Compare stock trading platforms

While CFDs are illegal in the US, you can still trade other investments, like stocks, ETFs, options and futures. Compare platforms to find one that offers the investments you’re interested in.

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Bottom line

Despite their flexibility and popularity in other parts of the world, CFDs are deemed too risky to be regulated in the US — so Americans are prohibited from trading them. But there are still ways to maximize price movements and manage risk using other investment strategies. Get an overview of your investment options first, then dig into the details of the investment options that best fit you.

Frequently asked questions

• What’s the difference between investing in stocks and trading in CFDs?

  When you trade CFDs, you never own the actual underlying asset. Instead, you bet on its price movements. In short, what you actually purchase is a contract.

  When you invest in stocks, however, you buy and sell the shares themselves.

• Do CFDs account for dividends paid to shareholders?

  When you buy stock in a company, you are usually entitled to dividends. And although trading CFDs means you never actually purchase the stock, you can still take advantage of some of the benefits of ownership.

  When you buy a CFD, your trading account will be credited with a certain amount of money that reflects the dividend amount an ordinary shareholder would receive. When you sell a CFD, your account will be debited a similar amount which will be paid to the counterparty.