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What is a Contract For Differences - CFD

Contract For Differences - CFD

A contract for differences (CFD) is an arrangement made in a futures contract whereby differences in settlement are made through cash payments, rather than by the delivery of physical goods or securities. This is generally an easier method of settlement, because both losses and gains are paid in cash. CFDs provide investors with the all the benefits and risks of owning a security without actually owning it.
The CFD is a tradable contract between a client and a broker, who are exchanging the difference in the current value of a share, currency, commodity or index and its value at the contract’s end.

Advantages of a Contract for Differences CFDs provide higher leverage than traditional trading. Standard leverage in the CFD market is as low as a 2% margin requirement and as high as a 20% one. Lower margin requirements mean less capital outlay and greater potential returns for the trader. Also, the CFD market is not bound by minimum amounts of capital or limited numbers of trades for day trading. An investor may open an account for as little as $1,000. In addition, because CFDs mirror corporate actions taking place, a CFD owner receives cash dividends and participates in stock splits, increasing the trader’s return on investment.

Most CFD brokers offer products in all major markets worldwide. Traders have easy access to any market that is open from the broker’s platform. Because of stock, index, treasury, currency, commodity and sector CFDs, traders of different financial vehicles benefit. The CFD market typically does not have short-selling rules. An instrument may be shorted at any time. Since there is no ownership of the underlying asset, there is no borrowing or shorting cost. In addition, few or no fees are charged for trading a CFD. Brokers make money from the trader paying the spread. A trader pays the ask price when buying, and takes the bid price when selling or shorting. Depending on the underlying asset’s volatility, the spread is small or large and typically fixed.

Disadvantages of a Contract for Differences Paying the spread on entries and exits prevents profiting from small moves, while decreasing winning trades and increasing losses by a small amount over the underlying asset. Since the CFD industry is not highly regulated, the broker’s credibility is based on reputation rather than life span or financial position. Because each day a trader holds a long position costs money, a CFD is not suitable for buy-and-hold trading or long-term positions.

Example of a traditional Futures/Options CFD for Crude Oil. A traditional CFD for crude oil would allow an investor to buy control of 1,000 barrels of oil for the price of $1,000 for the market price at time of purchase, controlled for a specific period of time. Should the price of oil increase by, say $3 a barrel, the investor has the option of selling his option and collecting the difference in value between the price when purchased and the price when sold.

This becomes the same as if the investor actually bought the oil at the original option price and sold at the increased price, hence the name, contract for difference. However, being an options contract, while the option is present to purchase an asset at a fixed price and allowing for that option to be sold at a higher price due to market conditions, there is no obligation under an options contract (CFD) to buy the asset should the price drop. Therefore, the risk in buying an options contract (CFD) is limited to the initial amount paid, No further risk can be endure. Of course, there are strategies to limit risk so as not to lose the entire cost of the CFD, so the upside is always unlimited and downside is always under control.