Contract for Difference (CFD)

A contract for difference (CFD) is a contract between a buyer and a seller. Under the contract the seller will pay to the buyer the difference between the current value of a specified financial instrument and its value at contract time. The specified financial instrument could be a share or a bond - or a portfolio of shares, such as an index, or even a mix of different assets. If the difference is negative, then the buyer pays instead to the seller. At the closing of the contract, the difference between the opening and closing prices is multiplied by the number of shares in the contract. A CFD is not a security like a bond or equity.

With CFDs, traders can take a long position if they think the price will rise, or take a short position if they think the price will fall. They make a profit or a loss depending on whether they have correctly predicted the direction in which the price will move. This means the trader can make money even if the price of a share falls, if he has predicted correctly and ‘gone short’ -  selling the stock he don’t own then buy it back later, at a lower price to make a profit.

In CFD dealing, one does not physically buy or hold the physical underlying share; one only has indirect access to the price performance but would benefit from a dividend payment. Contracts for difference offer all the benefits of trading shares without having to physically own them.

CFDs are dealt on a margin basis. The transaction is secured by paying a deposit. This deposit is known as a Notional Trading Requirement and is around 10% of the contract value. CFD trading operates on a basis similar to margin trading. The investor never becomes the physical owner of the shares - a trader can purchase shares on a CFD, without having the total required amount. The shares are never transported to the investor. Money is borrowed to buy shares, gaining the benefits of a regular shareholder, whilst the bank profits on interest from the credit. All this takes place simultaneously under one contract. CFD trading gives an investor greater flexibility as well as being a means for saving money. It is an effective and convenient method of trading in shares, commodities or futures.

The relationship between an investor and a CFD provider or broker is more along the lines of a traditional stockbroker, who acts as agent. Most CFD providers allow investors to post orders within the bid-offer spread giving access to the greater liquidity of the main market and more importantly enabling the investor to become a price maker rather than a price taker. The broker earns commission on the trade and charges a funding charge on the borrowed funds. The CFD provider may also provide supporting reports and research, be a source of commentary and opinion and be able to relay market gossip and stories, often invaluable information.

When an investor takes out a CFD, he must make the Notional Trading Requirement Deposit of about 10% of the contract value. CFDs can remain open as long as the investor wants and so the CFD must always have sufficient collateral support to cover potential losses. If a CFD moves into a loss-making position, then the broker can make a margin call – the investor must deposit additional funds to ensure that the CFD remains solvent and is not closed by the broker.

CFDs offer many benefits to both shareholders who wish to contract their shares and to traders who wish to invest in shares without incurring the regular risks and pitfalls. The specifications of CFDs which vary widely can be stipulated by the involved parties. This offers both parties greater flexibility with custom-made requirements to suit individual needs. CFDs restrict losses whilst maximizing profits. It is an ideal entry to the stock exchange market. CFDs are frequently traded in conjunction with the Forex currency trading system; they are also an effective and convenient speculative instrument for trading shares, indices, futures and commodities

Investors use CFDs for short term trading, Paris trading and Hedging. Short term trading provides the investor with the ability to deal on a margin basis and makes CFDs attractive for investors hoping to benefit from short term price movements. In Paris trading, the investor takes a long CFD in a company which he believes is undervalued while going short on another more expensive share in the same sector. Investors also use CFDs to hedge against price falls in existing shareholdings. Investors can take out a short CFD in the shares rather than selling the actual shareholding to buy them back later, and this often proves to be less expensive. If the share price falls, then investor would lose money on the shareholding but make money on the CFD. If the share price goes up, then although the investor would lose money on the CFD, the shareholding would have increased in value.

CFDs can also be used as a vehicle for tax efficient trading. An investor who has an existing holding in a company can sell CFDs against this, allowing him to control the time at which he crystallizes capital gains or losses. This is especially useful around the end of the financial year.

With CFDs, investors can buy exposure to financial assets for a fraction of the cost of buying those assets for real. With CFDs the investor does not actually own the shares and so the investor does not receive all the privileges normally associated with share ownership, such as voting or invitations to AGMs.

As CFDs have become more popular, the provider fees have been bid down by competition. Investment firms hedge their own exposure to the CFD contract by investing in the trade specified by the client.

CFDs offer exposure to the markets at a small percentage of the cost of owning the actual share. This allows the investor to buy or sell an instrument, which usually costs only 10 per cent of the price of the underlying share. It offers great leverage opportunities.

All CFDs deals are made at once without waiting for execution and the minimum deal size with a CFD is usually 0.1 lots which equal 10 shares.

If an investor has money tied up in a short position CFD, the CFD provider or broker firm will pay interest on that money. If the investor actually sells the stock instead of just purchasing the short CFD, he will be able to earn interest on the proceeds of the sale. Since he is not earning this interest, the CFD Broker will credit his account for the amount that he would have earned.

CFDs can be very risky and investors can suffer large losses if they do not cover their options properly. The best way to reduce and limit this risk is with a Guaranteed Stop Loss, a function, provided by CFD providers which, guarantees traders that if their CFD reaches a certain percentage of loss, it will automatically close, to ensure that further losses are not incurred.

Many CFD providers permit investors to purchase CFDs even after the market for the underlying asset is closed.
CFDs offer a wide variety of assets for investors to trade. All major stocks will be listed, as well as major indexes, commodities, currencies and sectors. Investors can create a diversified portfolio of CFDs.

CFDs do not have an exercise date. The only time constraint that CFDs have is interest charges for trading on Margin. CFDs last as long as the investor would like. The only way to terminate the CFD is by closing out the contract, and settling the difference.

CFDs are potentially more rewarding than conventional share trading, the risks and potential losses are also greater.

CFDs are not suitable for 'buy and forget' trading or long-term positions. Each day the investor maintains the position it costs money and so there is a time when CFDs become expensive.

CFDs are liable to capital gains tax at the investor's marginal tax rate after the annual allowance has been surpassed. CFD losses can be offset against future profits for tax purposes.

The rapid price movements in share price need to be monitored closely as they can dramatically alter an investor’s level of exposure. If a stock collapses due to an unexpected press announcement then investors who have purchased long in the stock runs the risk of heavy losses unless they are able to exit immediately.

CFDs contracts are made on a margin. The CFD provider or broker is effectively giving the investor a loan and the investor must pay interest on the margin that the CFD provider is providing.

CFDs do not confer the voting rights of the underlying assets upon the investor.

The guarantees stop loss is expensive and has a limited life. When a short position is opened on a CFD, the investor’s account will be charged if the underlying shares earn dividends. If the investor had actually sold the stock, instead of using the CFD, he would not receive the income from the dividend; therefore this loss in income is represented in his account.

Due to the restrictions by the Securities and Exchange Commission, CFDs are not permitted in the US or Canada.

For even more information visit: http://en.wikipedia.org/wiki/Contract_for_difference

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