A contract for difference, or more commonly known as a CFD, is a contract between a buyer and a seller. CFDs are financial instruments that allow brokers to “bet” or speculate on the volatility of different stocks and other instruments in the marketplace with the hope of making a profit.
The buyer will go “long”, meaning that he/she is hoping for the price of an equity to go up. You may however also go “short”, which essentially means that you are speculating that an equity’s value will drop. In other words, with CFDs, you can speculate on both a stock growing or dropping in value, without physically owning the asset(s) which you are trading on.
Contract for Differences (CFDs)
CFDs permit brokers to barter with the price volatility of securities and derivatives. Derivatives are monetary investments that are stemmed from an underlying asset. In Essence, CFDs are used by investors and financiers to bet if the price of the fundamental asset or security will climb or drop.
Traders can anticipate the price of CFDs moving up or down. Brokers who believe in an upward movement of a CFD in price will buy that CFD. Traders who predict the opposite movement will sell a position.
If the buyer of a CFD realizes that the asset's price is escalating, they will often offer their asset for sale. The difference between the purchasing price and the selling price is profit. The net difference representative of the benefit or loss from the operations is resolved through the investor's brokerage account.
CFDs allow traders or brokers to trade currencies, indices, treasuries, shares, bonds, and commodities on the financial markets. All of this without ever owning the underlying securities.
Transacting in CFDs
CFDs may be applied in the trade of numerous assets and indemnities, as well as exchange-traded funds better known as ETFs. Brokers will utilize these products to speculate on the price changes in commodity futures contracts, for example, corn, crude oil, or even soybeans. Futures contracts are standard “deals” or agreements on contracts with obligations to buy or sell a specific asset at a predetermined price with a future termination date.
Even though CFDs permit investors to exchange the price actions of futures, they are not futures contracts. CFDs do not have termination dates comprising predetermined prices but rather trade like any other securities with buying and selling prices.
CFDs are traded “over the counter” (OTC) via a structure of traders which establish the market’s supply and demand for CFDs and render prices appropriately. CFDs are not traded on the main exchanges like the New York Stock Exchange. A CFD is a contract between a client/principal and a trader, bartering the difference in the initial price of a trade and the value when the trade is reversed.
CFDs offer dealers the advantages as well as the risks of possessing a security without really owning it.
Another advantage of CFDs is the fact that they are traded “on margin”, which means that the broker lets investors borrow money to add leverage. In other words, to increase the monetary size of the position to increase potential profits. Brokers will require traders to have certain amounts of assets before they allow these types of operations.
Trading with marginal CFDs normally provides the trader with greater leverage than conventional trading. Let’s say you can benefit from a margin of 10. This means that for a $10’000 position, you will only need $1’000 as capital.
Other advantages of CFDs include fewer regulations when compared to other standard exchanges. In other words, CFDs can have reduced investment conditions and therefore require less cash in a brokerage account. This means that traders do not need as much money to open an account with a broker and since CFDs oftentimes reflect corporate or commercial activities someone owning CFDs is entitled to collect dividends, which in turn increases a trader’s return. Most of the time CFD brokers present traders with products in all the global markets.
Investors trading CFDs can go long or take a short position, as well as buy or sell their positions. In the CFD market, there are no “short-selling” regulations which mean that a product can be shorted whenever a trader wishes to do so. There are no “shorting costs” because there is no actual physical possession of a given asset. There are also very few, or in some cases, no fees for trading CFDs, making them attractive to investors. Brokers earn a commission from the spread which implies that the trader pays the asking price when buying a product and gets the bid price when they short. Brokers make a commission or a spread on every bidding and asking price which they execute.
When there is severe volatility in the markets and the product in question is affected, the spread on the bid and ask price can be substantial. Large spreads will affect the prices paid by the trader when entering and exiting positions and this will negatively affect trades and increase losses. Because the CFD industry is not stringently regulated, CFDs are not offered in the United States.
Because CFDs are traded using leverage, which may seem beneficial, traders are at risk of losing all their funds. A margin call is when a trader is required to either close all their positions or add more funds to their account, in the case that they owe borrowed money to the broker. Being able to win more using the money you do not possess, also means risking losing the money you don’t have. If the equity falls below the price you would be able to reimburse, positions will be close automatically.
An Example of a CFD
Let us take an example so you can wrap your head around how CFDs work. We will take the example of buying a CFD and see a case of profit and a case of loss.
You are XYZ company which is trading at $390/$394 (sell/buy). Let’s say you want to buy 100 share CFDs because your intuition tells you the price will go up. XYZ has a margin rate of 10%, which means that you only have to deposit 10% of the total trade value as a position margin.
You will therefore need to deposit $3’940 (10%x(100 (shares) x $394 (buy price))) instead of the $39’400 that you would have had to pay without margin. While your profit may be much higher than normal with such a small investment, the loss can be much higher as well.
If things go right and you make a profit:
Yay, you made a profit. The price rose to $430/$434 within the next day, thanks to great news about the company. So, you decide to sell this position and cash in your profit, at the new sell price, which is $430.
The price went up $36 ($430 (sell price) - $394 (buy price)). Your gross profit is therefore the price difference times the number of CFDs you acquired: $36 x 100 = $3’600.
We still need to take away the commissions you had to pay when buy and selling the position. Quite simple:
100 (CFDs you bought) x $394 x 0.12% = $47.28
100 (CFDs you bought) x $430 x 0.12% = $51.6
The net profit becomes $3’600 – ($47.28 + $51.6) = $3’501.12
You almost doubled your investment in a day!
If things go wrong and you do not profit:
Whoops, bad call. The price went down to $345/$350 within the next day, because of bad news announced by the company. Your fear that the price will drop even more and you decide to sell and cut your losses.
The price dropped by $49 ($345 (sell price) - $394 (buy price)). Your gross loss is therefore the price difference times the number of CFDs you acquired: $49 x 100 = $4’900.
You lost, but the broker will still ask you to pay the due commissions for buying and selling the position. Quite simple:
100 (CFDs you bought) x $394 x 0.12% = $47.28
100 (CFDs you bought) x $345 x 0.12% = $41.4
The net profit becomes $4’900 + ($47.28 + $41.4) = - $4’988
You lost more than you invested !
As you can see with this example, CFDs with margin trading can be very rewarding, but also extremely risky if you do not do your calculations right, so be careful!
CFDs are leveraged products. CFD trading may not be suitable for everyone and can result in losses that exceed your deposits, so please consider our Risk Disclosure Notice and ensure that you fully understand the risks involved.