CFD

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Contract for Differences (CFD)

What Is a Contract for Differences (CFD)?

A contract for differences (CFD) is an arrangement made in financial derivatives trading where the differences in the settlement between the open and closing trade prices are cash-settled. There is no delivery of physical goods or securities with CFDs.

Contracts for differences is an advanced trading strategy that is used by experienced traders and is not allowed in the United States.

Key Takeaways

  • A contract for differences (CFD) is a financial contract that pays the differences in the settlement price between the open and closing trades.
  • CFDs essentially allow investors to trade the direction of securities over the very short-term and are especially popular in FX and commodities products.
  • CFDs are cash-settled but use allow ample margin trading so that investors need only put up a small amount of the contract’s notional payoff.

Understanding Contract for Differences

CFDs allow traders to trade in the price movement of securities and derivatives. Derivatives are financial investments that are derived from an underlying asset. Essentially, CFDs are used by investors to make price bets as to whether the price of the underlying asset or security will rise or fall.

CFD traders may bet on the price moving up or downward. Traders who expect an upward movement in price will buy the CFD, while those who see the opposite downward movement will sell an opening position.

Should the buyer of a CFD see the asset’s price rise, they will offer their holding for sale. The net difference between the purchase price and the sale price are netted together. The net difference representing the gain or loss from the trades is settled through the investor’s brokerage account.

Conversely, if a trader believes a security’s price will decline, an opening sell position can be placed. To close the position they must purchase an offsetting trade. Again, the net difference of the gain or loss is cash-settled through their account.

Contract for Differences (CFD)

Transacting in CDFs

Contracts for differences can be used to trade many assets and securities including exchange-traded funds (ETFs). Traders will also use these products to speculate on the price moves in commodity futures contracts such as those for crude oil and corn. Futures contracts are standardized agreements or contracts with obligations to buy or sell a particular asset at a preset price with a future expiration date.

Although CFDs allow investors to trade the price movements of futures, they are not futures contracts by themselves. CFDs do not have expiration dates containing preset prices but trade like other securities with buy and sell prices.

CFDs trade over-the-counter (OTC) through a network of brokers that organize the market demand and supply for CFDs and make prices accordingly. In other words, CFDs are not traded on major exchanges such as the New York Stock Exchange (NYSE). The CFD is a tradable contract between a client and the broker, who are exchanging the difference in the initial price of the trade and its value when the trade is unwound or reversed.

Advantages of a CFD

CFDs provide traders with all of the benefits and risks of owning a security without actually owning it or having to take any physical delivery of the asset.

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CFDs are traded on margin meaning the broker allows investors to borrow money to increase leverage or the size of the position to amply gains. Brokers will require traders to maintain specific account balances before they allow this type of transaction.

Trading on margin CFDs typically provides higher leverage than traditional trading. Standard leverage in the CFD market can be as low as a 2% margin requirement and as high as a 20% margin. Lower margin requirements mean less capital outlay and greater potential returns for the trader.

Typically, fewer rules and regulations surround the CFD market as compared to standard exchanges. As a result, CFDs can have lower capital requirements or cash required in a brokerage account. Often, traders can open an account for as little as $1,000 with a broker. Also, since CFDs mirror corporate actions taking place, a CFD owner can receive cash dividends increasing the trader’s return on investment. Most CFD brokers offer products in all major markets worldwide. Traders have easy access to any market that is open from the broker’s platform.

CFDs allow investors to easily take a long or short position or a buy and sell position. The CFD market typically does not have short-selling rules. An instrument may be shorted at any time. Since there is no ownership of the underlying asset, there is no borrowing or shorting cost. Also, few or no fees are charged for trading a CFD. Brokers make money from the trader paying the spread meaning the trader pays the ask price when buying, and takes the bid price when selling or shorting. The brokers take a piece or spread on each bid and ask price that they quote.

Disadvantages of a CFD

If the underlying asset experiences extreme volatility or price fluctuations, the spread on the bid and ask prices can be significant. Paying a large spread on entries and exits prevents profiting from small moves in CFDs decreasing the number of winning trades while increasing losses.

Since the CFD industry is not highly regulated, the broker’s credibility is based on its reputation and financial viability. As a result, CFDs are not available in the United States.

Since CFDs trade using leverage, investors holding a losing position can get a margin call from their broker, which requires additional funds to be deposited to balance out the losing position. Although leverage can amplify gains with CFDs, leverage can also magnify losses and traders are at risk of losing 100% of their investment. Also, if money is borrowed from a broker to trade, the trader will be charged a daily interest rate amount.

CFDs allow investors to trade the price movement of assets including ETFs, stock indices, and commodity futures.

CFDs provide investors with all of the benefits and risks of owning a security without actually owning it.

CFDs use leverage allowing investors to put up a small percentage of the trade amount with a broker.

CFDs allow investors to easily take a long or short position or a buy and sell position.

Although leverage can amplify gains with CFDs, leverage can also magnify losses.

Extreme price volatility or fluctuations can lead to wide spreads between the bid (buy) and ask (sell) prices from a broker.

The CFD industry is not highly regulated, not allowed in the U.S., and traders are reliant on a broker’s credibility and reputation.

Investors holding a losing position can get a margin call from their broker requiring the deposit of additional funds.

Real-World Example of a CFD

An investor wants to buy a CFD on the SPDR S&P 500 (SPY), which is an exchange traded fund that tracks the S&P 500 Index. The broker requires 5% down for the trade.

The investor buys 100 shares of the SPY for $250 per share for a $25,000 position from which only 5% or $1,250 is paid initially to the broker.

Two months later the SPY is trading at $300 per share, and the trader exits the position with a profit of $50 per share or $5,000 in total.

The CFD is cash-settled; the initial position of $25,000 and the closing position of $30,000 ($300 * 100 shares) are netted out, and the gain of $5,000 is credited to the investor’s account.

An Introduction to CFDs

The contract for differences (CFD) offers European traders and investors an opportunity to profit from price movement without owning the underlying asset. It’s a relatively simple security calculated by the asset’s movement between trade entry and exit, computing only the price change without consideration of the asset’s underlying value.   This is accomplished through a contract between client and broker and does not utilize any stock, forex, commodity, or futures exchange. Trading CFDs offers several major advantages that have increased the instruments‘ enormous popularity in the past decade.

Key Takeaways

  • A contract for differences (CFD) is an agreement between an investor and a CFD broker to exchange the difference in the value of a financial product between the time the contract opens and closes.
  • A CFD investor never actually owns the underlying asset but instead receives revenue based on the price change of that asset.
  • Some advantages of CFDs include access to the underlying asset at a lower cost than buying the asset outright, ease of execution, and the ability to go long or short.
  • A disadvantage of CFDs is the immediate decrease of the investor’s initial position, which is reduced by the size of the spread upon entering the CFD.
  • Other CFD risks include weak industry regulation, potential lack of liquidity, and the need to maintain an adequate margin.

How a CFD Works

If a stock has an ask price of $25.26 and the trader buys 100 shares, the cost of the transaction is $2,526 plus commission and fees. This trade requires at least $1,263 in free cash at a traditional broker in a 50% margin account, while a CFD broker requires just a 5% margin, or $126.30.

A CFD trade will show a loss equal to the size of the spread at the time of the transaction. If the spread is 5 cents, the stock needs to gain 5 cents for the position to hit the break-even price. While you’ll see a 5-cent gain if you owned the stock outright, you would have also paid a commission and incurred a larger capital outlay.

If the stock rallies to a bid price of $25.76 in a traditional broker account, it can be sold for a $50 gain or $50/$1,263 = 3.95% profit. However, when the national exchange reaches this price, the CFD bid price may only be $25.74. The CFD profit will be lower because the trader must exit at the bid price and the spread is larger than on the regular market.

In this example, the CFD trader earns an estimated $48 or $48/$126.30 = 38% return on investment. The CFD broker may also require the trader to buy at a higher initial price, $25.28 for example. Even so, the $46 to $48 earned on the CFD trade denotes a net profit, while the $50 profit from owning the stock outright doesn’t include commissions or other fees. Thus, the CFD trader ends up with more money in their pocket.

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What is a contract for difference?

A contract for difference (CFD) is a popular form of derivative trading. CFD trading enables you to speculate on the rising or falling prices of fast-moving global financial markets (or instruments) such as shares, indices, commodities, currencies and treasuries.

CFD trading explained

Some of the benefits of CFD trading are that you can trade on margin, and you can go short (sell) if you think prices will go down or go long (buy) if you think prices will rise. CFDs are tax efficient in the UK, meaning there is no stamp duty to pay*. You can also use CFD trades to hedge an existing physical portfolio.

Introduction to CFD trading: how does CFD trading work?

With CFD trading, you don’t buy or sell the underlying asset (for example a physical share, currency pair or commodity). You buy or sell a number of units for a particular instrument depending on whether you think prices will go up or down. We offer CFDs on a wide range of global markets and our CFD instruments includes shares, treasuries, currency pairs, commodities and stock indices such as the UK 100, which aggregates the price movements of all the stocks listed on the FTSE 100.

For every point the price of the instrument moves in your favour, you gain multiples of the number of CFD units you have bought or sold. For every point the price moves against you, you will make a loss.

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What is margin and leverage?

CFDs are a leveraged product, which means that you only need to deposit a small percentage of the full value of the trade in order to open a position. This is called ‘trading on margin’ (or margin requirement). While trading on margin allows you to magnify your returns, your losses will also be magnified as they are based on the full value of the CFD position.

What are the costs of CFD trading?

Spread: When trading CFDs you must pay the spread, which is the difference between the buy and sell price. You enter a buy trade using the buy price quoted and exit using the sell price. The narrower the spread, the less the price needs to move in your favour before you start to make a profit, or if the price moves against you, a loss. We offer consistently competitive spreads.

Holding costs: at the end of each trading day (at 5pm New York time), any positions open in your account may be subject to a charge called a ‚holding cost‘. The holding cost can be positive or negative depending on the direction of your position and the applicable holding rate.

Market data fees: to trade or view our price data for share CFDs, you must activate the relevant market data subscription for which a fee will be charged. View our market data fees

Commission (only applicable for shares): you must also pay a separate commission charge when you trade share CFDs. Commission on UK-based shares on our CFD platform starts from 0.10% of the full exposure of the position, and there is a minimum commission charge of £9. View the examples below to see how to calculate commissions on share CFDs.

Please note: CFD trades incur a commission charge when the trade is opened as well as when it is closed. The above calculation can be applied for a closing trade; the only difference is that you use the exit price rather than the entry price.

What instruments can I trade?

When you trade CFDs with us, you can take a position on over 10,000 CFD instruments. Our spreads start from 0.7 points on forex pairs including EUR/USD and AUD/USD. You can also trade the UK 100 and Germany 30 from 1 point and Gold from 0.3 points. See our range of markets

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Example of a CFD trade

Buying a company share in a rising market (going long)

In this example, UK Company ABC is trading at 98 / 100 (where 98pence is the sell price and 100pence is the buy price). The spread is 2.

You think the company’s price is going to go up so you decide to open a long position by buying 10,000 CFDs, or ‘units’ at 100 pence. A separate commission charge of £10 would be applied when you open the trade, as 0.10% of the trade size is £10 (10,000 units x 100p = £10,000 x 0.10%).

Company ABC has a margin rate of 3%, which means you only have to deposit 3% of the total value of the trade as position margin. Therefore, in this example your position margin will be £300 (10,000 units x 100p = £10,000 x 3%).

Remember that if the price moves against you, it’s possible to lose more than your margin of £300, as losses will be based on the full value of the position.

Outcome A: a profitable trade

Let’s assume your prediction was correct and the price rises over the next week to 110 / 112. You decide to close your buy trade by selling at 110 pence (the current sell price). Remember, commission is charged when you exit a trade too, so a charge of £11 would be applied when you close the trade, as 0.10% of the trade size is £11 (10,000 units x 110p = £11,000 x 0.10%).

The price has moved 10 pence in your favour, from 100 pence (the initial buy price or opening price) to 110 pence (the current sell price or closing price). Multiply this by the number of units you bought (10,000) to calculate your profit of £1000, then subtract the total commission charge (£10 at entry + £11 at exit = £21) which results in a total profit of £979.

Outcome B: a losing trade

Unfortunately, your prediction was wrong and the price of Company ABC drops over the next week to 93 / 95. You think the price is likely to continue dropping so, to limit your losses, you decide to sell at 93 pence (the current sell price) to close the trade. As commission is charged when you exit a trade too, a charge of £9.30 would apply, as 0.10% of the trade size is £9.30 (10,000 units x 93p = £9,300 x 0.10%).

The price has moved 7 pence against you, from 100 pence (the initial buy price) to 93 pence (the current sell price). Multiply this by the number of units you bought (10,000) to calculate your loss of £700, plus the total commission charge (£10 at entry + £9.30 at exit = £19.30) which results in a total loss of £719.30.

Short-selling CFDs in a falling market

CFD trading enables you to sell (short) an instrument if you believe it will fall in value, with the aim of profiting from the predicted downward price move. If your prediction turns out to be correct, you can buy the instrument back at a lower price to make a profit. If you are incorrect and the value rises, you will make a loss. This loss can exceed your deposits.

Hedging your physical portfolio with CFD trading

If you have already invested in an existing portfolio of physical shares with another broker and you think they may lose some of their value over the short term, you can hedge your physical shares using CFDs. By short selling the same shares as CFDs, you can try and make a profit from the short-term downtrend to offset any loss from your existing portfolio.

For example, say you hold £5000 worth of physical ABC Corp shares in your portfolio; you could hold a short position or short sell the equivalent value of ABC Corp with CFDs. Then, if ABC Corp’s share price falls in the underlying market, the loss in value of your physical share portfolio could potentially be offset by the profit made on your short selling CFD trade. You could then close out your CFD trade to secure your profit as the short-term downtrend comes to an end and the value of your physical shares starts to rise again.

Using CFDs to hedge physical share portfolios is a popular strategy for many investors, especially in volatile markets.

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