Contracts for Difference or more commonly CFD’s are a type of financial derivative which allow you trade to financial instruments without owning the underlying asset. CFD’s are a derivative as the price of the instrument is derived from the underlying asset value. CFD’s are the most popular OTC (over the counter) derivative due to the fact CFD trading is the closest one can get to trading the underlying asset without actually owning the said instrument. CFD’s were first developed in the early 90’s and soon became popular with hedge funds, before being introduced to retail clients in the late 90’s becoming massively popular with many seeking easy access to the global financial markets.
A CFD is a contract between two parties based (often described as the buyer and seller) on the underlying price of a particular asset, with the contract stipulating that the seller (usually a CFD brokerage) will pay the buyer the difference between the current asset value and the asset price as stipulated in the original contract. If the difference between the values is negative it is the buyer (usually a retail customer) that pays the difference.
CFD Trading Examples
While all of this may sound incredibly complicated it can be demonstrated very easily by a couple of simple examples.
|Instrument||Price at Opening of Contract||Bid (Sell) – Offer (Buy) Spread||Number of Contracts (Buy/Sell||Price at Close of Contract||Profit/(Loss)/td>|
|Big Bank Plc.||$1.03||$1.00 – $1.05||100 (Buy||$1.10>||$5|
|Big Bank Plc.||$1.03||$1.00 – $1.05||100 (Sell)||$1.05||($5)|
In the first example, the buyer enters into a Contract with the provider to buy a 100 Shares (strictly speaking Contracts as the buyer doesn’t own the underlying asset) of Big Bank Plc. If the price of Big Bank Plc rises above $1.05 the buyer makes a profit, in our example Big Bank’s share price hit $1.10 which saw our trader closing his position and exiting the contract. Making himself a profit of $5 which is the difference between the offer at the time of entering into the contract and the price of the asset when he closed or exited the contract ($0.05 x 100).
In the second example, the buyer enters into a Contract with the provider to Sell a 100 shares of Big Bank Plc. If the price of Big Bank Plc had dropped down to $1.00 the trader would have hit his breakeven point and if the price had fallen further he would have bagged the difference between the price and the bid. So if the price had fallen to $0.87 he would have made $0.13 multiplied by the number of contracts entered into (100) and made himself a $13 profit. But as it would happen the price moved further against him leading him to make a five dollar loss before he decided to close the contract.
Traders who enter into a Contract for differences are required to a certain amount of margin (cash to cover the trade) as defined by the brokerage in order to keep a particular position open. Margin requirements can range from (0.5% to up 30%); a brokerage which has a margin requirement of 10% would require our trader in the above examples to have at least $10.30 (10% of the value of the trade which equals $1.03×100) in his account to open the position. However, if in the second example the trader had run up losses of more than $10.30 he would have received a margin call where he would be required to either close his position or alternatively deposit more funds. It is in this way that you can lose more money than your initial deposit when you trade CFD’s, however this also gives you increased leverage allowing you to trade on a larger scale than you could if you were required to put up all the funds beforehand.
This is in essence how contracts for difference work, though CFD’s do vary from provider to provider. For example some providers charge a fixed commission every time a new position is open while others calculated this commission into the Bid – Offer spread. While a Contract for difference is open ended with no predetermined close date, there may also be overnight costs associated with keeping the position open for more than one trading day. Again these overnight costs vary from provider to provider. As you can see CFD’s allow individuals to speculate on financial instruments in a way extremely similar to trading shares but with the benefit of significant leverage (the low margin requirement means you can trade greater positions with less initial capital) and the ability to go both short and long in a particular instrument without any major fuss.