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What is a contract for difference (CFD)?
What is a contract for difference (CFD)?

What is a contract for difference (CFD)?

They allow customers to trade freely without having to actually own the underlying asset or acquire any right or obligation. The main benefit of trading with CFDs is the flexibility they offer in terms of enabling you to trade against share movements without buying or selling the physical instrument.

Learn about the benefits and drawbacks of this powerful market instrument and how to use it to your advantage.

What are CFDs?

A CFD, or Contract for Difference, is essentially a contract between an investor and an intermediary (broker or investment bank). This intermediary will then bill or pay the difference between the current price of the underlying asset and its quoted price on an unspecified date. 

CFDs have no fixed maturity, meaning that the contract entered into between the intermediary and client has no end date. Instead, the client is able to terminate the contract whenever he or she chooses. This characteristic is one of the major benefits of this product over traditional futures.

Put simply, CFDs are financial instruments derived from stocks that enable investors to profit from share movements without requiring them to own the physical assets. The underlying asset might be an index, a commodity, a precious metal, shares, etc.

How do CFDs work?

CFDs allow you to invest both in the rise and fall of a given asset. If we do an upside investment (we open a long position), we will have as profit the upwards difference in the price of the stock (e.g. if we open a $10 position and close it at $11, the profit would be one dollar since there is an upwards difference: $11 - $10 = $1).

If, however, we choose to complete a downside investment (we open a short position), our profit will be the difference between the contract settlement price and the closing price  (e.g. if we open a $10 position and close at $9, the profit would still be one dollar as there is a difference to the downside)

The calculation will always be the same: sell price - buy price. A trade will generate a profit whenever the sell price is higher than the buy price.

Note: This calculation does not include any broker commission and/or financing expenses which pay be payable

Thus, CFDs enable traders to make profit irrespective of the market situation, i.e. both in markets that are on the rise as well as in downtrending markets. It goes without saying that if we open a bearish position and the market behaves contrary to our predictions (i.e. it rises instead of falls), then we will incur a loss. The same would apply if we open a long position and the market falls.

In short, CFDs can help you earn some quick cash, while also representing an emergency lifeline in case you start losing money!

What are margin and leverage?

Perhaps a better question would be: what is the relationship between margin and leverage?

Margin is a good faith deposit required to maintain open positions.

Leverage, on the other hand, is a byproduct of margin and allows an individual to control larger trade sizes.

"Leverage" and "margin" essentially refer to the same concept, only from a slightly different angle. When a trader opens a position, they are required to provide a fraction of its value as a gesture of "good faith". In this case, the trader is considered to be "leveraged". The minimum amount that must be charged is known as the "Margin Requirement".

Do be aware that CFDs are a leveraged product, which means that you only need to deposit a small percentage of the total trade value in order to open a position. In other words, you only need put up a small amount of money to control a much larger amount, thus enabling you to increase the potential return on your investment. But don't forget that this means that your loss potential will be similarly amplified, so you must be sure to manage this additional risk.

Long and short CFD portfolios

Using a long or short option involves betting on a Contract for Difference moving up or down in value. The difference between your long and short option represents your post-trade profit or loss.

When you open a "long position", you purchase an asset in the hope that its value will increase.  Its name comes from the phrase "long term", the logic being that markets tend to rise gradually over a much longer period of time than they fall. Thus, opening a long position means buying.

A "Short position", on the other hand, is when you sell an asset in the hope that it will decrease in value.  This name derives from the phrase "short term" since markets typically fall sharply in a short space of time. Therefore, opening a short position means selling.

What are the associated costs of CFDs trading?

  • Spread: when trading CFDs, you must pay the spread (the difference between the buy price and the sell price). When you enter the market, the price you pay is known as the buy price. The sell price is what you receive on exiting. The smaller the spread, the less the price needs to move in your favour before you start making a profit (or loss in the event that the price moves against you). At Libertex, we make sure we consistently offer our customers competitive spreads.

Spread

  • Maintenance fees: at the end of each trading day, any open position in your account may be subject to a charge known as a "maintenance fee". Maintenance fees may be positive or negative depending on the direction of your position and the applicable maintenance rate.
  • Commission: you must also pay a separate commission fee when exchanging CFDs.

You can read more about Libertex's trading terms here.

Libertex provides all its affiliates with the following:

  • Leverage up to 1:500
  • Trading on any device from just one platform: Libertex or Metatrader 4/5
  • Free demo account access
  • 24/5 technical support for traders
  • No commissions for withdrawals within Latin America
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