What is a CFD?

Contract for difference (CFD) trading offers investors and traders the opportunity to trade on stocks, indices, foreign exchange, commodities and bonds using leverage; that is, they can trade on markets with a deposit (referred to as ‘margin’) that only amounts to a fraction of the total notional value of the trade.

Contracts for Difference, or CFDs for short are financial instruments where the buyer receives or pays to the seller the difference in a company’s share price over time, giving the holder an economic interest in the company but no direct ownership of its stock.

GUIDE to CFDS

As technology improves, so does the way that you are able to invest and manage your money. There are now many aspects of the investment world in which you can actively trade in, not just shares.

In fact there are various types of CFDs. They include share CFDs, index CFDs, sector CFDs, FX CFDs, CFDs on commodities and CFDs on international shares. In addition to UK and Australian shares, most providers now also offer International share CFDs including US, European, and Asian shares. This means you can trade share CFDs on Google, Apple, Amazon, Wal-Mart, Honda, Toyota, Vodafone, BMW, British Airways and other big brands that may not available in the local market.

What are CFDs and how do they Work?

A contract for difference or CFD as it is commonly referred to is a contract between two parties, typically described as ‘buyer’ and ‘seller’, stipulating that the seller will pay to the buyer the difference between the current value of an asset and its value at contract time. (if the difference is negative, then the buyer pays instead to the seller). In effect, CFDs are financial derivatives that allow investors to take advantage of prices moving up (long positions) or prices moving down (short positions) on underlying financial instruments and are often used to speculate on those markets.

In essence, a contract for difference consists of an agreement or contract between two parties (for example, you and the CFD provider) to exchange the difference in value between the opening and closing price of a particular financial product, such as a share.

When you trade CFDs, you take a position on the change in value of the underlying asset between the moment the contract is opened and the time it is closed. You are essentially speculating on whether the value of an underlying asset is going to rise or fall in the future compared to what it was when the contract was taken out (or executed). In other words, CFD trading is opened at a specific prevailing market price and closed at the reigning market price and the client is entitled to the difference.

For example, when applied to shares, such a contract is an equity derivative that allows investors to speculate on share price movements, without the need for ownership of the underlying shares.

Major banks and hedge funds utilise contracts for differences to cap their downside exposure and for opening up larger potential profits than may be possible through traditional shares trading. Private investors are now increasingly using CFDs in a similar way, which has led to them becoming one of the world’s fastest growing ways to trade the financial markets.*

Contracts for Difference were once only available to major institutions. Private investors are now taking advantage of the opportunities this product offers. Used with prudence a CFD can be a wonderful tool for investors to maximise returns from a small initial outlay.

* CMC Markets UK Plc, July 2008

An Example

Here is an example of a CFD trader. Supposing that the minimum margin requirement for FTSE 100 shares at IG Markets is 3% – if a trader bought 10,000 CFDs of Vodafone at a price of £1.50, they would need a minimum of £450 in their account in order to open the trade ([10,000 x £1.50] x 3% = £450) as opposed to £15,000 had they bought the 10,000 stocks via a traditional stock broker.

CFD Examples

Imagine the physical purchase of 1,000 Barclays shares at 200p each. By investing the same amount of capital, you could buy a CFD representing 10,000 shares.

Action Buying Shares Buying a CFD
Opening Value £2,000 £20,000
Commission (0.5%) £10 £100
Stamp Duty (0.5% on shares) £10 £0
Deposit Required (10% for CFD) £2,000 £2,000

After 5 days you sell at a profit. Your selling price is 220p per share. Your deposit is returned to you, together with your profit.

Action Selling shares Selling a CFD
Closing Value £2,200 £22,000
Commission (0.5%) £11 £110
Financing Charges (libor +3%) NIL £13.70 approx.
Deposit Required (10% for CFD) £2,000 £2,000
Net Profit £169 £1,776.30
% Return On Equity 8.45% 88.80%

This outcome assumes a favourable result, however if Barclays shares had dropped the leverage effect would have magnified your losses.

A CFD is a contract of a standard quantity of a specific underlying financial asset, usually a listed share. Usually, this means that one CFD contract is equal to one underlying share.

Simplified CFD Index Example

Here’s how a simplified CFD long trade might work, disregarding financing interest and any commissions:

An investor notes the FTSE 100 at 5,900 and thinks it has further to rise.

The CFD provider’s quote is 5,899-5,901
Buy to open at 5,901
The trader commits to one contract
Value of investment (£1 x index value): £5,901
Margin of 1%: £59.01

A week later the index has risen to 6,000
The CFD provider’s quote is 5,999-6,001
Sell to close at 5,999
Value of investment: £5,999
Trading profit (£5,999 minus £5,901): £98
Profit margin on funds deposited (£98 ÷ £59): 66%

If used carefully CFDs need not be money pits. They’re speculative trading opportunities. They’re not contracts for difference, but contracts which can make a difference.