Introduction to CFDs

How Does a CFD Work? The CFD (short for Contract For Difference) is a contract between two parties.  Each party agrees to settle the contract at a predetermined date in the future with the difference in the opening and closing prices being paid.  If the price of the underlying asset has gone in favour of the buyer then the seller will pay the difference to them.  The opposite is true if the price moves against the buyer.

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

History of CFDs

CFD trading has been available to retail clients since the late 1990’s and they were quickly marketed by a number of UK derivative providers with investors keen to get involved. CFD providers quickly expanded their range of markets available to trade from initially just the London stock exchange to Dow Jones, Nasdaq, S&P500, DAX, ASX200 and many more. The simplicity of CFD trading and the rise of the internet made it easy for providers to offer clients state of the art trading platforms to execute trades and monitor the markets without the need of an actual broker thus reducing costs to the client and raising the profit margins of the providers.

CFD providers have now expanded overseas with Australia being introduced to this innovative market in 2002 and retail markets opening up in Europe and Canada.

One of the latest developments in CFDs has occurred in Australia with the first regulated CFD exchange opening its doors in November 2007.

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.

What Is a CFD?

You may have heard about CFD trading, and wondered what it was. Does trading a CFD give you any advantage over ordinary trading of shares or indexes? The answer is definitely yes. The idea behind the initials CFD is very simple, and it can have significant advantages in terms of leveraging your assets and making money in trading.

A CFD is a derivative, which just means that it is not an asset in itself, like a share, a car or a house, but a financial contract that “derives” its value from an asset. You may be familiar with futures and options, both of which are similar in that they have a value derived from an underlying security. The name CFD stands for Contract for Difference, and this describes fairly clearly what the CFD is.

The value for a CFD comes from a difference or change in the price of a security or commodity. The Contract for Difference is a binding contract that requires payment for or makes profit from that change in price.

Why is a CFD so great for making a profit? Because it allows you to leverage your investment, that is multiply the effectiveness of your money, by a factor of ten or twenty compared to ordinary trading. This means that if you only have a limited amount to invest, you can still make a good profit, and if you have more trading capital, you can achieve excellent returns.

A note of caution, however – just as the CFD can multiply your profits, it can also multiply your losses, so you need to know what you are doing when you start trading CFDs. You will find this website a valuable resource as it explains about all the various types of CFDs and gives you tips and information to help start you out trading profitably.

CFDs have only been around for a very short time in financial terms. They were invented in London less than twenty years ago, and were based on the original idea of equity swaps, which is a tool which can create a payment for the difference in the future between two sources of cash flow, but is quite often used just to get around taxes and legislation when investing.

Originally used by hedge funds and institutional investors, CFDs got around paying the UK stamp duty, and provided a means to hedge stock investments. In a few years the concept became available to the ordinary investor, and they are now available in several other countries, most notably Australia, where they are rapidly becoming a popular trading tool. They are not allowed in the USA yet, where the Securities and Exchange Commission have stricter investing controls.

In practice a CFD is similar to a futures contract, but with a little more flexibility. A futures contract, as you may know, is a contract to agree to make a certain transaction in the future – for instance, to buy 1000 shares of IBM. The futures contract specifies the price to be paid and the date on which the deal will be done. Futures contracts are bought and sold all the time, so you don’t always have to go through with the actual deal yourself – you may find someone to buy the contract from you for a profit.

Historically, one of the original reasons for a futures contract was for farmers to agree a price in advance for their crops so that they could be sure of how much they would earn. Food suppliers benefited by agreeing to buy in advance so that they knew how much they would have to pay. These contracts were used as a hedge against large movements in the price, and allowed the buyers and sellers to plan for the future with more certainty.

A Contract for Difference works in the same basic way, but is set up to be a simpler trading tool. It is recognized at the outset that the CFD is traded for profit rather than because the parties involved actually want to buy or sell the underlying security or commodity, and the difference is simply paid out to settle the contract.

Unlike futures, there is no set date for the contract to be fulfilled, and no standard sizes to be traded. You can trade the amount that you want, and the difference that is paid out is the true difference from when you bought into the position to when you choose to exit it.

As mentioned above, when you trade CFDs you leverage your investment, so that you are “trading on margin” to buy into the position. As you do not have to find the total value of the shares or securities that you are trading, you are effectively borrowing the money from your broker which means that you will be charged a certain amount of interest for every day that you are in the trade.

In a similar way to futures, CFDs are “marked to market”. This means that any increase in value is credited to your account straight away, rather than waiting for you to sell the CFD. The downside of this is that any drawdown in value is also reflected in your account on the same day, which can result in a “margin call” or request for more money from your broker.

When you use margins for trading, you can achieve much better returns for your cash outlay. You are employing “Other People’s Money” to increase your interest in the commodity or share. The caveat is that it also exposes you to losing money more readily, and you owe it to yourself to study and research carefully before you start trading.