Contract for Difference

What is CFD?

CFD is an acronym for “Contract for Difference”. It is a contract between a buyer and a seller which stipulates the buyer either to pay the seller the difference in the value of the contract when it is complete, or to collect the difference if the price change is in the buyers' favour. A CFD allows a trader access to various assets without actually taking ownership of those assets. With a CFD it is possible to speculate on the price change of an asset. CFDs convey a number of benefits that have made them extremely popular over the past decade.

How does CFD trading work?

A CFD is a contract between a trader and their broker to exchange the difference in value of an underlying financial asset between the time when the contract is opened and the time when it closes. It is a trading strategy whereby there is no actual ownership of the underlying asset, thus no delivery of the asset. That means a trader can speculate on the price movement of an asset without worrying over ownership issues.

Basically, a trader can use the CFD to speculate on price movements of an asset. Traders can open a long position if they believe the price of the asset will rise, or a short position if they think the price of the asset will fall. There are no short sale rules or minimum holding period for the CFD.

What assets can you trade with CFDs?

CFDs are extremely flexible and include pretty much any asset class, presuming the trader is able to find a broker who is willing to take the other side of the trade. In practice the most commonly traded CFDs include:

• Currency pairs such as EUR/USD or USD/CAD
• Commodities such as gold, silver, and crude oil
• Global stock indices
• Global ETFs
• Bonds
• Individual company shares
• Cryptocurrencies

Because so many different assets are available, these allow traders for various diversification strategies.

Profit and Loss

One of the advantages of trading with CFDs is the use of leverage and margin, which makes the cost of entering a position much lower than with the traditional tradin/leverage-margin/g methods. This leverage can also greatly increase both profits and losses as illustrated by the example below.

Suppose gold is trading at $1,900 an ounce and you believe the price will increase. You can open a long gold CFD position to take advantage of this potential increase in price.

With traditional trading you might be able to open a mini-contract for 10 ounces of gold which would cost $19,000 ($1,900 * 10). That's a lot of money. However, with leverage available, the same position might only require 5% of the total value, which means you could open a position on 10 ounces of gold for just $950 ($1,900 *10 * 5%).

If the price of an ounce of gold increases to $1,950 you could potentially make $500 on the traditional trade (less commissions and fees). That's effectively just over 2.5% profit. You would also make $500 if the price increases to $1,950, however since you only invested $950 to begin with, you are getting a return of more than 50% on your investment. That's a huge difference.

Bear in mind that the same applies with losses as well. If the price of gold were to fall by $50, in this hypothetical situation, your loss would be greater than 50% too.

Risks of CFD Trading

CFDs are fast moving investment products and there is a chance of large losses when positions aren't closely monitored, particularly when high levels of leverage are being used. There are liquidity risks and margin levels that must be maintained which increases the risks further.

In addition, many CFD brokers are unregulated, or at best lightly regulated, which places traders at greater risk. There are a variety of trusted CFD brokers available, but in general the credibility of any CFD broker is primarily based on its longevity in the industry, its reputation among traders and the financial position of the broker.