Definition of Contract for Difference (CFD)
CFD is an acronym for contrast for differences. A contract for difference is made between an investor and the broker and just like stock it is traded on an exchange except one thing trading a CFD on asset does not mean that you own that asset. It allows the trader to make a profit from the difference in price movement without owning the asset. It is a simple security which is calculated by the asset’s movement from trade entry and exit points.
How A CFD Works
For example, assume you are an investor and a company produces medical instruments. You notice that the company is thriving recently, so you assume that the company’s shares will go high so you will buy a bunch of shares of the company and wait for them to skyrocket, but what if the rise in the price is minimal. Another option is to buy a CFD on this share and take a long position if the price goes up as you predicted you will receive the difference between the opening and the closing prices. The higher the price goes, the more money you will receive. But if you think that the company’s shares will fall, then you can sell the CFDs on the company’s shares and go short. Now you will profit from the lowering of the prices, as much they fall as much profit you will get.
Advantages of CFDs
- The biggest and brightest advantage of a CFD is that you can go long or short margins. You can speculate on a movement up in price and can speculate on a movement down in price.
- CFD provides a higher leverage than other trading methods. It allows you to trade with a minimum capital. The standard leverage is subjected to regulation. The maintenance margin of CFD used to be 2% (50:1 leverage) but now the maintenance margin is 3% (30:1 leverage) and is supposed to go up to 50% (2:1 leverage). As the lower margin requirements means less capital for the investor and greater returns.
- CFD investors can trade on a wide range of about 4000 markets globally as the CFD brokers offer products in all the major markets of the world.
- Certain markets don’t allow the seller shorting without borrowing the instrument to sell short. But CFD instruments can be sold short without borrowing the instrument because the investor does not own the underlying asset.
- There is no stamp duty to pay in the CFD trading because there is no asset changing hence no hares changing. You just have to pay the commission, which is a little bit high than share.
- The trader has the favor of out of hour trading.
Disadvantages of CFD
- The main problem is the re-quotes and crossing the price spread with CFD providers.
- Trading CFDs is riskier than trading shares, because if you don’t profit from the trade you can lose your capital and if the market moves against you, you might need to either contribute more cash or sell your assets.
- The easy access and a low capital requirement often lead the traders to over-trading.
- If appropriate money management techniques are not applied, leverage can be risky. Because leverage not only profits are magnified on a marginal trading but, losses are also magnified.
- The CFD trader has to pay interest on the total transaction market exposure, regardless of the margin that they have subsidized.
Adam Fent is a forex trader who has been involved in the markets since he was a teenager. He started out by day trading penny stocks, and eventually transitioned to Forex because of its liquidity and 24-hour nature.
He has been consistently profitable for the past several years, and is always looking to improve his trading skills. When he’s not trading, he enjoys spending time with his wife and two young children.