A CFD, or Contract for Difference, is an agreement between two parties to exchange the difference between the opening price and closing price of a contract.
CFDs are derivatives products that allow you to trade on live market price movements without actually owning the underlying instrument on which your contract is based.
A trader can use CFDs to speculate on the future movement of market prices regardless of whether the underlying markets are rising or falling.
A trader can go short, allowing you to profit from falling prices, or hedge his or her portfolio to offset any potential loss in value of your physical investments.
It is possible to trade any of the thousands of securities or currency markets with CFDs.
To understand how CFDs work, it is best to use the example of a single instrument, in this case, a stock. If a stock has an ask price of $25.26 and 100 shares are bought at this price, the cost of the transaction is $2,526.
With a traditional broker, using a 50% margin, the trade would require at least a $1,263 cash outlay from the trader. With a CFD broker, often only a 5% margin is required, so this trade can be entered for a cash outlay of only $126.30.
When a trader enters a CFD trade, the position will show a loss equal to the size of the spread which covers the broker’s commission.
So if the spread is 5 cents with the CFD broker, the stock will need to appreciate 5 cents for the position to be at a breakeven price. The broker takes the commission through the spread, so there is no percentage commission on the sale, as there would be with a traditional broker. It is the same procedure as is used in most forex trading.
If the underlying stock were to continue to appreciate and the stock reached a bid price of $25.76, the owned stock can be sold for a $50 gain or $50/$1263=3.95 per cent profit.
At the point the underlying stock is at $25.76, the CFD bid price may only be $25.74. Since the trader must exit the CFD trade at the bid price, and the spread in the CFD is likely larger than it is in the actual stock market, a few cents in profit are likely to be given up.
Therefore, the CFD gain is an estimated $48 or $48/$126.30=38 per cent return on investment. The CFD may also require the trader to buy at a higher initial price, $25.28 for example.
Even so, the $46 to $48 is a real profit from the CFD, whereas the $50 profit from owning the stock does not account for commissions or other fees. In this case, it is likely the CFD would put more money in the trader's pocket.
CFDs provide much higher leverage than traditional trading. Standard leverage in the CFD market begins as low as a 2% margin requirement.
Depending on the underlying asset (shares for example), margin requirements may go up to 20 per cent. Lower margin requirements mean less capital outlay for the trader/investor, and greater potential returns.
However, increased leverage can also result in increased losses.
Most CFD brokers offer products in all the world's major markets.
This means traders can easily trade any market while that market is open from their broker's platform. Almost any financial product can be traded in the form of a CFD. There are almost no limits or restrictions.
Certain markets have rules that prohibit shorting at certain times, require the trader to borrow the instrument before shorting or have different margin requirements for shorting as opposed to being long.
The CFD market generally does not have short selling rules. An instrument can be shorted at any time, and since there is no ownership of the actual underlying asset, there is no borrowing or shorting cost.
The trader should always bear in mind that with leverage comes with significant benefits and risks: your investment capital can go further, but you can also lose more than your initial deposit.
CFD trading allows you to take a position on the future value of an asset whether you think it will go up or down. While this means the product is very flexible, it also requires a high level of risk management.
Each position you take, with a small deposit, exposes you to a much larger loss.
The trader should also be aware that the CFD industry is not highly regulated. The credibility of an individual broker is based on reputation, life span and financial position.
There are many reputable CFD brokers, but it is important, as with any trading decision, to investigate whom to trade with and which broker best fulfils your trading needs.