The contract for difference (CFD) is a relatively complex financial instrument that offers traders the opportunity to profit from price movement without owning an asset and without consideration of the asset’s value. Since its development in the 1990s, CFD trading has become a popular instrument in recent years because it requires less capital and offers greater potential returns than a traditional trade, but the increased leverage can also amplify losses.
CFD trading enables traders to take a position on whether an asset, such as stocks, currencies, or commodities, will rise or fall in price. The trader enters into an agreement with a broker to exchange the difference in the price of the asset from the moment at which the contract is opened to when it is closed.
Long or short
To speculate whether an asset will go up or down in price traders choose either a “long” or “short” position. If they believe an asset’s value will rise then they will take a long position, while if they think the value will fall they will choose to short. The key to CFD trading is the difference in price of an asset between the point at which a contract is opened to when it is closed: the trader can profit on both rises and falls in price if they predict the market correctly. This contrasts with traditional stock trading where investors only profit when the value of an asset increases and they would sell their shares if they believed the value of an asset was about to fall.
Leverage is what makes CFDs an attractive proposition for traders as it means less capital outlay upfront, but can also magnify losses when a contract is closed. In a standard stock trade, if a trader wanted to buy 100 Apple shares at $120 each then they would need to pay $12,000 for the shares upfront. However, as CFDs are focused on the difference in price not the value of the shares themselves, CFD traders may only need to put up 20 per cent of the cost upfront, a strategy known as leverage.
Whilst leverage allows traders to spread their capital further, it is important to understand that the profit or loss from the contract will be calculated on the full price of the position. In the example above, whilst a CFD trader may only need to have initially put up £2,400, the eventual profit or loss would be calculated on the full 100 shares at the end of the contract. Leverage is limited to between 3% (30:1 leverage) and 50% (2:1 leverage), and while a larger leverage could mean higher profits for the same outlay it can also mean magnified losses, which can exceed deposits. Therefore, it is critical that traders can cover any losses and only trade within their means.
Fees and commission
Many CFD brokers offer the same order types as traditional brokers such as limits, stops, and contingent orders and may charge fees on such options. However, many brokers do not charge fees of commission on trades, instead generating their profits when the trader pays the spread. To buy a contract the trader must pay the ask price, and to short a position the trader must pay the bid price, with the spread where the brokers make their money.
Contracts for difference offer an alternative way for traders to gamble on the fluctuations of global markets without the capital required for traditional asset trades. However, it is important to understand how leverage can exacerbate losses and so trade in a more informed and safer manner.