What is a Contract for Difference (CFD)
A contract for difference or CFD for short is an instrument where the buyer receives or pays the seller the difference in an asset’s price over time, giving the CFD holder an economic interest in the company without any direct ownership of the shares.
You can buy contracts for difference on particular shares and forex pairs. The difference is represented by the change in value of an asset, between the time the contract is opened and when it is closed. So a CFD contract is an agreement between two parties to settle at the difference between the opening price and closing price of an asset specified in the contract at a particular point in time. Inother words, a CFD is opened at a specific current market price at a point in time and closed at the reigning market price and the investor is entitled to the difference.
A CFD is made of a contract of a standard quantity of a particular underlying asset, usually a listed share but can also be an index, foreign exchange pair or commodity. In the case of a CFD share this usually means that one CFD contract is equivalent to one underlying stock in the company.
What are CFDs: Leveraged Trading Products
CFDs are leveraged products which means that they are traded on margin implying that you don’t have to pay the full price of the underlying market exposure. The only requirement is that you pay into your account sufficient monies to cover the initial margin. Therefore you might only need $10,000 to purchase CFD contracts up to a value of $100,000. If you investment rises to $130,000 which equals a 30% rise in value of the investment – you will actually stand to make a 300% ROI (return on investment), as you only deposited $10,000 initially.
Buy and Sell Financial Assets with Equal Ease
One important characteristic of a CFD is that you are able to both ‘buy’ or ‘sell’ an instrument meaning you can open both ‘long’ and ‘short’ positions. A ‘long’ trade involves purchasing the contracts and selling them again at a future date, hopefully after the price has risen. Therefore “long” positions stand to make money in a rising market. A ‘short’ position is the opposite – selling contracts first and buying them back later, in the expectation of a fall in price.
So how can your broker permit you to ‘short’ a stock you don’t own?
In the background, your DMA CFD broker will usually borrow stocks on your behalf thus allowing you to sell them even if they don’t belong to you. If you manage to buy them back at a lower price, you will make money. Therefore “short” positions make money in a falling market.
To conclude CFDs are powerful trading products that will benefit active traders and investors who are looking at making their money work harder for them. However, contracts for difference also need to be traded with care as they are leveraged trading instruments that may result in substantial losses if the market trades against you.