As the name suggests, a contract for difference (CFD) is an agreement between a broker and an investor. It stipulates that the difference between the starting value of a security and its closing value at the end of the contract will be paid out to one party or the other.
This means that a broker would pay out to an investor who correctly predicts a market change. However, if the market moves against the investor, then it is the broker who profits from the difference.
In more technical terms, a CFD is a short-term derivative that is constructed to pay out in cash to individual investors or speculators. The values of these investments are based on changes of a financial instrument’s market value, without actually transferring ownership of any of these shares, currencies, or commodities.
How does a contract for difference work?
Unlike regular securities that are traded through exchanges, contracts for difference are traded over-the-counter by a network of brokers, who coordinate supply and demand and set appropriate prices. Leveraged investments like CFDs are designed in such a way that allows investors to trade on margins linked to a given asset’s price in relation to its market value.
A contract for difference essentially gives you the right to speculate on upward or downward changes in price without having to hold on to actual stocks, bonds, gold, or other securities.
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Investors can choose to buy a contract for difference hoping for a price increase (“go long”) or sell an opening position in anticipation of a price decrease (“go short”) on margin. This means that if the margin is 1:10 you would only have to pay $100 of a $1,000 share value.
But wait, where does the other $900 come from? Thanks to leverage, brokers are able to cover that difference without taking on much risk.
Costs related to contracts for difference
As touched on above, the margin is a deposit of a predetermined part of the full value of a security.
Here are a few other terms (all of them are costs) that you might encounter when dealing with contracts for difference:
Spread
The spread is the difference between the buy and sell price when you enter and exit a CFD trade, respectively. A narrower spread means the price doesn’t need to move as much before you make either a profit or loss on the trade.
Holding costs
These are charged on positions left open at the end of each trading day (usually 5pm), and can either be positive or negative based on the direction of the spread and any applicable holding rates.
Market data fees
These are charged by brokers for allowing you to trade or view price data (basically a fee to avail of CFD services).
Commissions
These are only applicable to trades involving shares, and the rates may depend on the exchange that these shares are traded on.
Advantages of contracts for difference
Contracts for difference draw traders from all over because they commonly present favorable margins, and here are a few other advantages that make these attractive investment options:
- The first and most obvious advantage of trading CFDs is that they can be far less expensive than trading actual assets, giving you more affordable access to blue-chip shares and top trading commodities.
- CFDs can be used to hedge physical shares in your portfolio, especially in volatile markets where there is reason to expect that your shares may lose value in the short term.
- Since they are often traded on fast-moving global markets, CFDs open opportunities to trade in a wide range of sectors, stocks, indices, commodities, and currencies all over the world.
- CFDs are quite flexible, in the sense that there are no restrictions on when to enter or exit a position and benefiting from going long or selling short (depending on your chosen strategy).
Risks of contracts for differences
Any type of trading involves risk, and contracts of difference are no different. Here are some of the attached risks that you should consider before making an investment:
- CFD trading is not regulated, forcing traders to rely almost solely on a broker’s reputation and credibility. It is partially for this reason that these agreements are not allowed in the US.
- CFDs aren’t suitable for holding long-term positions or so-called “buy-and-forget” strategies that might apply to actual share investments, because they are charged for each day left open.
- Extreme price fluctuation or market volatility can result in wide spreads, which can result in riskier positions and make it more difficult to turn a profit on CFDs.
- While the leverage applicable to CFDs may amplify your profits, losses can also be magnified if the spread does not go in the direction that you expected.
The bottom line
Contracts for difference can be good short-term investment options for speculators looking to temporarily extend their asset holdings or quickly take advantage of market movements in either direction. Since CFDs present higher leverage and lower margin requirements than traditional trading, they often require a smaller capital outlay for potentially bigger returns.
However, these same features also increase your potential risk exposure, so make sure to do your homework before making that investment and be prepared to cut your position when you get the markets wrong.
Fortunately, investment resources like Academy can help you learn how to read the markets and make smarter guesses when it comes to betting on contracts for difference.
