What is a CFD (Contract for Difference)?
Contracts for difference (CFDs) are one of the world’s fastest-growing trading instruments. A contracts for difference creates, as its name suggests, a contract between two parties speculating on the movement of an asset price. The term ‘CFD’ which stands for ‘contract for difference’ consists of an agreement (contract) to exchange the difference in value of a particular currency, commodity share or index between the time at which a contract is opened and the time at which it is closed. The contract payout will amount to the difference in the price of the asset between the time the contract is opened and the time it is closed. If the asset rises in price, the buyer receives cash from the seller, and vice versa. There is no restriction on the entry or exit price of a CFD, no time limit is placed on when this exchange happens and no restriction is placed on buying first or selling first. CFDs are traded on leverage to give traders more trading power, flexibility and opportunities.
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Contracts for Difference Workings
First, let’s go back to the definition of a CFD. A CFD is an agreement to exchange the difference between the entry price and exit price of an underlying asset. For instance, if you buy a contracts for difference at $14 and sell at $16 then you will receive the $2 difference. If you buy a CFD at $10 and sell at $8 then you pay the $2 difference.
A CFD allows a trader to gain access to the movement in the share price by putting down a small amount of cash known as a margin. Trades are conducted on a leveraged basis with margins typically ranging from 1% to 80% of the face value of the financial instrument. For indices or currencies, these margin requirements can be as low as 1 percent of the underlying value of the security.
When you enter a CFD contract you are not buying the underlying share, even though the movement of the CFD is directly linked to the share price. In fact, CFDs mirror the movement and pricing of the underlying share. However, since you do not own the share, you are only required to provide a deposit to your CFD provider which could be as low as 5% for blue chip shares. This means you can trade up to 20 times your initial capital and it thus possible to create significant profit through ‘margin’ as you only have to use a deposit to hold a position, meaning only a small proportion of the total value of a position is needed to trade allowing the client to magnify market exposure. For instance, with a stock CFD that requires a 5 per cent margin to open a trade, a 5 per cent increase in the market price of the underlying stock results in a stunning 100 per cent return on the investor’s capital. However, this cuts both ways and there need only be a 5 per cent fall in the market price of the share to result in a 100 per cent loss for the investor.
CFDs do not have an expiry date like options or futures contracts. As opposed to an expiry date a CFD is effectively renewed at the close of each trading day and rolled forward if desired – you can keep your position open indefinitely, providing there is enough margin in your account to support the position. In this stance contracts for differences are very similar to futures without an expiration date. While the contract remains open, your account with the provider will be debited or credited to reflect interest and dividend adjustments.
One of the great features of CFDs is that you are able to trade on both the long and the short side of the market i.e. you can choose to ‘long’ or ‘short’ a position – if you are long, you receive dividends and pay interest, if you are short you do the reverse. It is worth noting that commission is paid on either side of the contract and you can close a contract at any time.
Going Long, Going Short
- Trading the long side in practice means that you have used a buy instruction as your opening CFD trade or ‘gone long’. For trading shares ‘going long’ refers to opening a buy CFD position to profit from a share price increase. This implies that you are expecting a rise in the asset’s price and will use a sell order to close your position.
- Trading the short side means that you have opened your CFD trade using a sell order or ‘gone short’. For trading shares ‘Going short’ refers to opening a sell CFD position to profit from a share price decrease. This means that you are anticipating stock prices to fall and will use a buy order to close your position (although this may sound a bit weird it is really another way you close out your position in the market). The benefit of short trading is that you can profit directly from falling asset prices, which is difficult to do without the use of products such as contracts for differences.
- CFDs are available on a huge range of different assets including global indices, stocks, sectors, currencies and commodities.
- Unlike futures contracts, CFDs have no fixed expiry date or contract size. Positions are renewed at the close of each trading day and may be rolled forward indefinitely provided there is sufficient margin to support it.
- Trades are conducted on a leveraged basis so you only need to deposit a percentage (typically from 5-10% to for shares and 1% for indices) of the total value of the trade. Leveraged trading means potential profits and losses are magnified.
- While a trade remains open, your CFD account will be debited or credited to reflect daily financing costs and dividend adjustments.
- You can go long or short. If you go long, you are entitled to dividends and pay daily interest (financing), if short, the reverse is applicable.
- CFDs reflect the price movements and pricing of the underlying stock on which they are based. You usually deal at the cash market price.
- CFDs provide access to the movement in the share price by putting down a small amount of the total market exposure – this is referred to as a margin.
- There is NO restriction on the entry or exit price of a contract for difference, there is no time limit to exchange the price difference in the asset, nor is there any restriction on buying first or selling first. No actual shares are physically bought or sold and you never have ownership of the underlying asset.
- Positions can be closed at anytime during normal market hours.
- A CFD can only be closed by making a second, ‘reverse’ trade to your original ‘long’ or ‘short’ position.
- Commission is paid on each side of a CFD trade i.e. a commission for opening a trade and a separate commission for closing the trade. This is usually calculated on the underlying contract value.
- Cash flows on trades are calculated each day.
- You are liable to CGT, but not stamp duty.
- CFDs are not standardised products and every CFD broker has their own terms and conditions.