What is a Contract for Difference (CFD)?
A contract for differences (CFD) is an arrangement made in financial derivatives trading where the differences in the settlement between the open and closing trade prices are cash-settled. There is no delivery of physical goods or securities with CFDs.
Contracts for differences is an advanced trading strategy that is used by experienced traders and is not allowed in the United States.
A contract for differences (CFD) is a financial contract that pays the differences in the settlement price between the open and closing trades.
CFDs essentially allow investors to trade the direction of securities over the very short-term and are especially popular in FX and commodities products.
CFDs are cash-settled but usually allow ample margin trading so that investors need only put up a small amount of the contract’s notional payoff.
introduction of Contract for Differences
CFDs allow traders to trade in the price movement of securities and derivatives. Derivatives are financial investments that are derived from an underlying asset. Essentially, CFDs are used by investors to make price bets as to whether the price of the underlying asset or security will rise or fall.
CFD traders may bet on the price moving up or downward. Traders who expect an upward movement in price will buy the CFD, while those who see the opposite downward movement will sell an opening position.
Should the buyer of a CFD see the asset’s price rise, they will offer their holding for sale. The net difference between the purchase price and the sale price are netted together. The net difference representing the gain or loss from the trades is settled through the investor’s brokerage account.
Conversely, if a trader believes a security’s price will decline, an opening sell position can be placed. To close the position they must purchase an offsetting trade. Again, the net difference of the gain or loss is cash-settled through their account.
Common Terms of Contract for Difference
Trading Terms: Going Long vs Going Short
Going Long – When traders open a contract for difference position in anticipation of a price increase, they hope the underlying asset price will rise. For example, in the case of Joe, he expected that oil prices would increase. So we can say he traded on the long side.
Going Short – Using a contract for difference, traders can open a sell position based on anticipating a price decrease in the underlying asset. Trading from the sell-side is known as going short.
Relationship between Margin and Leverage
In CFDs contracts, traders don’t need to deposit the full value of a security to open a position. Instead, they can just deposit a portion of the total amount. The deposit is known as “margin”.
This makes CFDs a leveraged investment product. Leveraged investments amplify the effects (gains or losses) of price changes in the underlying security for investors.
Terms Related to Cost of CFD Trading
Spread – The spread is the difference between the bid and ask prices for a security. When buying, traders must pay the slightly higher ask price, and when selling they must accept the slightly lower bid price. The spread, therefore, represents a transaction cost to the trader, since the difference between the bid and ask prices must be subtracted from the overall profit or added to the overall loss.
Holding costs – These are charges over the open positions a trader may incur at the end of the trading day. They are positive or negative charges depending on the direction of the spread.
Commission charges – These are commissions that CFD brokers often charge for the trading of shares.
Market data fees – These are also broker-related costs. They are charges for exposure to CFD trading services.
Advantages of Contracts for Difference
- Because CFDs are unique and often come with favorable margins, they attract many brokers across the world. So, trading in CFDs should not be a challenge to any trader who is looking forward to investing in CFDs.
- CFDs trade in the fast-moving global financial markets. Therefore, traders get what is called direct market access (DMA), which gives them an opportunity to trade globally.
- Unlike other types of instruments that offer only a single opportunity, CFDs present a wide range of assets. They include global indices, sectors, currencies, stocks, and commodities.
- With CFDs, traders can benefit from either the rising or falling of asset prices.
- Traders in CFDs don’t need to invest the full amount. They only need to open buying or selling positions on margins.
Disadvantages of Contracts for Difference
- If the underlying asset experiences extreme volatility or price fluctuations, the spread on the bid and ask prices can be significant. Paying a large spread on entries and exits prevents profiting from small moves in CFDs decreasing the number of winning trades while increasing losses.
- Since the CFD industry is not highly regulated, the broker’s credibility is based on its reputation and financial viability. As a result, CFDs are not available in the United States.
- Since CFDs trade using leverage, investors holding a losing position can get a margin call from their broker, which requires additional funds to be deposited to balance out the losing position. Although leverage can amplify gains with CFDs, leverage can also magnify losses and traders are at risk of losing 100% of their investment. Also, if money is borrowed from a broker to trade, the trader will be charged a daily interest rate amount.
Example of a Contracts for Difference
An investor wants to buy a CFD on the SPDR S&P 500 (SPY), which is an exchange traded fund that tracks the S&P 500 Index. The broker requires 5% down for the trade.
The investor buys 100 shares of the SPY for $250 per share for a $25,000 position from which only 5% or $1,250 is paid initially to the broker.
Two months later the SPY is trading at $300 per share, and the trader exits the position with a profit of $50 per share or $5,000 in total.
The CFD is cash-settled; the initial position of $25,000 and the closing position of $30,000 ($300 * 100 shares) are netted out, and the gain of $5,000 is credited to the investor’s account.