CFD Survival Guide

Introduction to CFDs

Filed under CFDs Education

A Contract for Difference or CFD is essentially a high risk financial product, which trades on share prices and indices. This is a flexible way to trade the markets, which can be used whichever view an investor takes on the direction of the market.

A CFD is basically an agreement to exchange the difference in value of a financial instrument, such as a share, currency or commodity, between the time at which the contract is opened and the time at which it is closed, enabling an investor to profit (or suffer losses) on the underlying asset without actually owning the share, and enabling the investor to exploit or make losses from downward or upward price movements.

If we take shares as an example, each CFD would correspond to an individual company – such as BP, Rio Tinto or Barclays. It is quoted in exactly the same way, and its movement mirrors the ups and downs of the corresponding share, though with a wider spread, for the reasons explained below. You can buy or sell a CFD whenever you wish and you can choose to hold a position for months or merely a few hours. (CFD trading is regarded as a short term activity due to the financing costs of holding a position open, as CFD providers charge for holding the position overnight).

Unlike shares, you cannot take delivery of a CFD. Instead, you settle the difference between the opening and closing prices, and that difference is your profit or loss (subject to any charges or dividends paid or payable). You will not pay stamp duty (0.5% under current UK legislation) or any safekeeping or nominee charges.

They are useful for traders seeking greater flexibility in maximising profit (though they can also lead to greater losses) as well as hedging risk. CFDs are an efficient means of market participation, keeping costs low, and allowing you the potential to profit on any market movements.

CFDs are tradable using leverage, removing the need to tie up large amounts of capital, and instead trading on margin, an effective way of realizing larger profits from a small initial investment, but can of course lead to even larger losses if the trade is not successful. Trading on margin also involves the risk that if the market moves against you, you face the choice of adding additional funds to the account to cover your margin, or having your position closed out at a loss, leaving you with the obligation to cover any deficit.

‘Just as you prepare for life’s emergencies and sticky situations, professional traders always brace themselves for all market situations. Whether the market goes up or down or sideways, you will still see professional traders in the market – albeit with more focus on risk management and capital protection.’ – Eva Diaz, from her book Real Traders, Real Lives, Real Money

What Are CFDs?

CFDs can essentially be defined as contracts designed to make a short-term profit by reference to movements in the price of a share, but where the underlying share doesn’t change hands. CFDs allow investors to benefit from price movements in a stock without actually needing to own it, a sort of equity derivative. CFDs were introduced into the country in the early 1990s, but it has taken until the last 10 years for them to really capture the imagination. From virtually a standing start, CFDs are estimated to have captured over 30% of the London Stock Exchange trading volume. During a period when traditional stockbrokers are reporting a huge fall in demand, much of the LSE’s upturn is believed to have come from the sustained popularity of CFDs and spread betting.

A contract for difference (CFD) is essentially an agreement between two entities to exchange the difference in price between the opening and closing price of a contract that is based on the price of an underlying instrument (such as a share price). The profit or loss is determined by the difference between the two prices at which the contract is bought or sold. In essence, the CFD broker agrees that if the trade shows a profit the provider will pay this amount to the trader. If the trade is a loser, the trader pays the difference to the CFD broker. Hence the term ‘contract for difference’. In return for the provision of this service, the CFD provider charges interest on the money ‘lent’ to you to buy on margin, and pays you interest on any short positions. Interest calculations need to be taken into account on bought, or long, positions, because interest is calculated on any positions held overnight. Interest is calculated at the full face value of the position, and not just on the amount of margin you have used.

The contract for difference (CFD) business is booming: Analysts in the 2010 UK Financial Spread Betting and Contracts for Difference Report stated they expected an additional 9,000 CFD traders to enter the market in 2011. Additionally, a study by consultancy Tabb Group, Breaking Down the UK Equity Market, written by analysts Miranda Mizen and Will Rhode and published earlier this year, found that about €1.3 trillion ($1.8 trillion) of UK turnover is related to CFDs, accounting for 31 percent of total equity turnover, or half the executable market.