Trading Contracts For Difference (CFDs): Is It Right For You?

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By guest writer Anthony Prams from Smart Finance Mag

What Is A Contract For Difference (CFD)?

A Contract for Difference (CFD) is a financial product that represents a contract between two parties, usually described as the “buyer” and the “seller.” The two parties agree to pay the difference between the current value of an underlying asset (ex: a stock) and the value of that asset at contract-end. If the difference is positive, the seller pays the buyer. If it is negative, the buyer is the one who loses money. So apart from the brokerage commission, every dollar that one party loses, the other one will win it.

The CFD mirrors the performance of the asset, such as stocks, commodities, index, currencies and interest rates. No need for physical ownership of the underlying asset itself. In order words, one does not need to physically own a stock in order to gamble on the share price up or down movements.

How do CFDs work?

(Source: Money Smart)

Every CFD trade generally starts with the trader’s expectation of the future price of the underlying asset. ‘Going long’ means buying a CFD in the expectation that the underlying asset will increase in value. ‘Going short’ means selling a CFD with the expectation that the underlying asset will decrease in value.

For example, imagine you buy a CFD (‘go long’) over Company X’s shares. If the price of Company X’s shares rises and you close out your CFD, the seller of the CFD (the counterparty) will pay you the difference between the current price of the shares and the price when you took out the contract. However, if the price of Company X’s shares falls, then you would have to pay the difference in price to the seller of the contract. This could be many times the amount of money you originally put in, because of leveraging.

Leveraging means that, you only have to put in a fraction of the market value of the underlying asset when making a trade, sometimes as little as 1%. The remaining 99% of the value of the asset is covered by the CFD provider. Even though you only put up 1% of the value, you are entitled to the same gains or losses as if you had paid 100%. The actual percentage of the market value that you will be asked to put in will vary for different CFD providers, and for different underlying assets.

Why Use CFDs?

CFDs were originally developed in the early 1990s and used by hedge funds and institutional traders to hedge their exposure to adverse stock market movements. But today, these financial derivatives are mostly used on their own, by brokers and traders seeking high and quick profits through market speculation. Originally, CFDs were only accessible to institutional investors. Their popularity has grown in recent years, especially among small investors trading through Internet platforms as online brokers worldwide.

Where are CFDs traded?

CFDs are derivative products traded OTC (over the counter) because they are not listed on an organized market. CFDs are forbidden in several countries, but are presently used in Canada, most countries in Europe and Asia. In the United States CFDs qualifies as security-based swaps.

Pros: Advantages of CFDs

Like other derivatives, CFDs have the advantage of providing liquidity to the market, and a greater access to financial markets, since the margin requirement to place a trade is much lower than for traditional assets. CFDs also provide an excellent vehicle for short term trading strategies and are the preferred vehicle amongst hedge funds and professional traders. CFDs are gaining ground to traditional investments due to their advantages; flexibility of operation and easy access to markets. CFDs may also provide tax gains compared to other financial instruments.

Cons: Disadvantages of CFDs

Since CFDs are leveraged products, one must be aware that there is a risk losses will exceed the initial deposit. Plus there may be high costs associated with each trade, as a spread must be paid to enter and exit positions. Costs may be low for short-term trading, provided you get the markets right.  However each day you maintain the position it costs money (if you are long), so CFDs may become expensive when large price movements do not occur.

While CFDs are very flexible products, good risk management is required. Indeed typical risks include investment risk (the risk of losing money if the underlying asset price moves against you), liquidity risk (trades may not be fulfilled at the moment you would like them to be) and counterparty risk (the risk of not getting paid by the CFD provider or other counterparties).

What Is The Difference Between CFDs And Options?

CFDs and options have a lot of similarities: they both make use of leverage and allow traders to make profits from the price variation of an asset they do not necessarily own. However unlike CFDs, put or call options require the buyer to pay a premium, and money is made if the option is in the money, otherwise the option expires unexercised and the only loss incurred is the premium. On the other hand, CFDs have no expiration date, and profits and losses are directly linked to the appreciation or depreciation of the underlying asset.

Is CFDs for You?

Today CFDs are used by many online brokers. Different brokers use different levels of leverage but it is still always risky to invest when one does not have an extensive understanding of the market. CFDs may not be suitable for all investors, since they are often recommended for short-term positions.

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