What's LFX?

Let’s have a comprehensive understanding of LFX

What Is a Contract for Differences (LFX)?

A contract for differences (LFX) is a contract between a buyer and a seller that stipulates that the buyer must pay the seller the difference between the current value of an asset and its value at contract time.

LFXs allow traders and investors an opportunity to profit from price movement without owning the underlying assets. The value of a LFX does not consider the asset’s underlying value, only the price change between the trade entry and exit.

This is accomplished through a contract between client and broker and does not utilize any stock, forex, commodity, or futures exchange. Trading LFXs offers several major advantages that have increased the instruments’ enormous popularity in the past decade.

KEY TAKEAWAYS

• A contract for differences (LFX) is an agreement between an investor and a LFX broker to exchange the difference in the value of a financial product between the time the contract opens and closes.

• A LFX investor never actually owns the underlying asset but instead receives revenue based on the price change of that asset.

• Some advantages of LFXs include access to the underlying asset at a lower cost than buying the asset outright, ease of execution, and the ability to go long or short.

• A disadvantage of LFXs is the immediate decrease of the investor’s initial position, which is reduced by the size of the spread upon entering the LFX.

• Other LFX risks include weak industry regulation, potential lack of liquidity, and the need to maintain an adequate margin.

How Contracts for Differences (LFXs) Work

A contract for differences (LFX) is an agreement between an investor and a LFX broker to exchange the difference in the value of a financial product (securities or derivatives) between the time the contract opens and closes.

It is an advanced trading strategy that is utilized by experienced traders only. There is no delivery of physical goods or securities with LFXs. A LFX investor never actually owns the underlying asset but instead receives revenue based on the price change of that asset. For example, instead of buying or selling physical gold, a trader can simply speculate on whether the price of gold will go up or down.

Essentially, investors can use LFXs to make bets about whether or not the price of the underlying asset or security will rise or fall. Traders can bet on either upward or downward movements. If the trader who has purchased a LFX sees the asset’s price increase, they will offer their holding for sale.

The net difference between the purchase price and the sale price is determined. The net difference representing the gain from the trades is settled through the investor’s brokerage account.

On the other hand, if the trader believes that the asset’s value will decline, an opening sell position can be placed. To close the position, the trader must purchase an offsetting trade. Then, the net difference of the loss is cash-settled through their account.

Countries Where You Can Trade LFXs

LFXs are not allowed in the United States. They are allowed in listed, over-the-counter (OTC) markets in many major trading countries, including the United Kingdom, Australia, Germany, Switzerland, Singapore, Spain, France, South Africa, Canada, New Zealand, Sweden, Norway, Italy, Thailand, Belgium, Denmark, and the Netherlands, as well as the Hong Kong special administrative region.1

The U.S. Securities and Exchange Commission (SEC) has restricted the trading of LFXs in the United States, but nonresidents can trade using them.2

As worldwide equities markets tumbled in 2022, investor interest in LFX trading also declined. A downturn in Google searches related to LFXs reflected the lower levels of engagement with the trading strategy. Declines in trading revenue by brokerage firms that offer LFX trading also signaled this downswing.3

The Costs of Trading LFXs

The costs of trading LFXs include a commission (in some cases), a financing cost (in certain situations), and the spread—the difference between the bid price (purchase price) and the offer price at the time you trade.

There is usually no commission for trading forex pairs and commodities; however, brokers typically charge a commission for stocks. For example, broker CMC Markets, a U.K.-based financial services company, charges commissions that start from 0.10%, or $0.02 per share, for U.S.- and Canadian-listed shares. The opening and closing trades constitute two separate trades, and thus you are charged a commission for each trade.4

A financing charge may apply if you take a long position. This is because overnight positions for a product are considered an investment (and the provider has lent the trader money to buy the asset). Traders are usually charged an interest charge on each of the days that they hold the position.

Example

For example, suppose that a trader wants to buy LFXs for the share price of GlaxoSmithKline. The trader places a £10,000 trade. The current price of GlaxoSmithKline is £23.50. The trader expects that the share price will increase to £24.80 per share. The bid-offer spread is 24.80–23.50.

The trader will pay a 0.1% commission on opening the position and another 0.1% when the position is closed. For a long position, the trader will be charged a financing charge overnight (normally the LIBOR interest rate plus 2.5%).

The trader buys 426 contracts at £23.50 per share, so their trading position is £10,011. Suppose that the share price of GlaxoSmithKline increases to £24.80 in 16 days. The initial value of the trade is £10,011, but the final value is £10,564.80.

The trader’s profit (before charges and commission) is as follows:

£10,564.80 - £10,011 = £553.80

Since the commission is 0.1%, the trader pays £10 upon entering the position. Suppose that interest charges are 7.5%, which must be paid on each of the 16 days that the trader holds the position (426 × £23.50 × 0.075 ÷ 365 = £2.06. Since the position is open for 16 days, the total charge is 16 × £2.06 = £32.92.).

When the position is closed, the trader must pay another 0.01% commission fee of £10.

The trader’s net profit is equal to profits minus charges:

553.80 (profit) - 10 (commission) - 32.92 (interest) - 10 (commission) = £500.88 (net profit)

Advantages of LFXs

Higher Leverage

LFXs provide higher leverage than traditional trading. Standard leverage in the LFX market is subject to regulation. It once was as low as a 2% maintenance margin (50:1 leverage) but is now limited to a range of 3% (30:1 leverage) and could go up to 50% (2:1 leverage). Lower margin requirements mean less capital outlay for the trader and greater potential returns; however, increased leverage can also magnify a trader’s losses.5

Global Market Access from One Platform

Many LFX brokers offer products in all of the world’s major markets, allowing around-the-clock access. Investors can trade LFXs on a wide range of worldwide markets.

No Shorting Rules or Borrowing Stock

Certain markets have rules that prohibit shorting, require the trader to borrow the instrument before selling short, or have different margin requirements for short and long positions. LFX instruments can be shorted at any time without borrowing costs because the trader doesn’t own the underlying asset.

Professional Execution With No Fees

LFX brokers offer many of the same order types as traditional brokers, including stops, limits, and contingent orders, such as “one cancels the other” and “if done.” Some brokers offering guaranteed stops will charge a fee for the service or recoup costs in another way.

Brokers make money when the trader pays the spread. Occasionally, they charge commissions or fees. To buy, a trader must pay the ask price, and to sell or short, the trader must pay the bid price. This spread may be small or large depending on the volatility of the underlying asset; fixed spreads are often available.

No Day Trading Requirements

Certain markets require minimum amounts of capital to day trade or place limits on the number of day trades that can be made within certain accounts. The LFX market is not bound by these restrictions, and all account holders can day trade if they wish. Accounts can often be opened for as little as $1,000, although $2,000 and $5,000 are common minimum deposit requirements.

Variety of Trading Opportunities

Brokers currently offer stock, index, treasury, currency, sector, and commodity LFXs. This enables speculators interested in diverse financial vehicles to trade LFXs as an alternative to exchanges.

Disadvantages of LFXs

Traders Pay the Spread

While LFXs offer an attractive alternative to traditional markets, they also present potential pitfalls. For one, having to pay the spread on entries and exits eliminates the potential to profit from small moves.

The spread also decreases winning trades by a small amount compared to the underlying security and will increase losses by a small amount. So, while traditional markets expose the trader to fees, regulations, commissions, and higher capital requirements, LFXs trim traders’ profits through spread costs.

Weak Industry Regulation

The LFX industry is not highly regulated. A LFX broker’s credibility is based on reputation, longevity, and financial position rather than government standing or liquidity. There are excellent LFX brokers, but it’s important to investigate a broker’s background before opening an account.

Risks

LFX trading is fast-moving and requires close monitoring. As a result, traders should be aware of the significant risks when trading LFXs. There are liquidity risks and margins that you need to maintain; if you cannot cover reductions in values, then your provider may close your position, and you’ll have to meet the loss no matter what subsequently happens to the underlying asset.

Leverage risks expose you to greater potential profits but also greater potential losses. While stop-loss limits are available from many LFX providers, they can’t guarantee that you won’t suffer losses, especially if there’s a market closure or a sharp price movement. Execution risks also may occur due to lags in trades.

Because the industry is not regulated and there are significant risks involved, LFXs are banned in the U.S. by the Securities and Exchange Commission (SEC).2

Example of a LFX Trade

Suppose that a stock has an ask price of $25.26 and the trader buys 100 shares. The cost of the transaction is $2,526 (plus any commission and fees). This trade requires at least $1,263 in free cash at a traditional broker in a 50% margin account, while a LFX broker requires just a 5% margin, or $126.30.

A LFX trade will show a loss equal to the size of the spread at the time of the transaction. If the spread is 5 cents, the stock needs to gain 5 cents for the position to hit the breakeven price. While you’ll see a 5-cent gain if you owned the stock outright, you would have also paid a commission and incurred a larger capital outlay.

If the stock rallies to a bid price of $25.76 in a traditional broker account, it can be sold for a $50 gain or $50 ÷ $1,263 = 3.95% profit; however, when the national exchange reaches this price, the LFX bid price may only be $25.74. The LFX profit will be lower because the trader must exit at the bid price and the spread is larger than on the regular market.

In this example, the LFX trader earns an estimated $48 or $48 ÷ $126.30 = 38% return on investment. The LFX broker may also require the trader to buy at a higher initial price—$25.28, for example. Even so, the $46 to $48 earned on the LFX trade denotes a net profit, while the $50 profit from owning the stock outright doesn’t include commissions or other fees. Thus, the LFX trader ends up with more money in their pocket.

Is Trading LFXs Safe?

Trading LFXs can be risky, and their potential advantages can sometimes overshadow the associated counterparty risk, market risk, client money risk, and liquidity risk. LFX trading can also be considered risky as a result of other factors, including poor industry regulation, a potential lack of liquidity, and the need to maintain an adequate margin due to leveraged losses.

Can You Make Money with LFXs?

Yes, it is possible to make money trading LFXs; however, trading LFXs is a risky strategy relative to other forms of trading. Most successful LFX traders are veteran traders with a wealth of experience and tactical acumen.

The Bottom Line

Advantages to LFX trading include lower margin requirements, easy access to global markets, no shorting or day trading rules, and little or no fees. However, high leverage magnifies losses when they occur, and having to pay a spread to enter and exit positions can be costly when large price movements do not occur. Indeed, the European Securities and Markets Authority (ESMA) has placed restrictions on LFXs to protect retail investors.