What is a contract for difference (CFD)?

09 Aug 2018

What is a contract for difference (CFD)?

CFD stands for Contract for Difference, and trading CFD's is a certain form of speculation in the financial markets where you don't need to buy or sell any underlying assets.

CFD's appeared in early 1990s in London as a form of margin stock trading. The invention of CFD's is generally attributed to Brian Keelan and Jon Wood, both from UBS Warburg, who developed these contracts while trading at Trafalgar House in early 90s.

Before CFD's were introduced, only participants with large capital could trade market instruments at international exchanges, such as stock exchanges, as the cost of trading in such exchanges can reach hundreds of thousands of dollars. CFD's opened access to market instruments trading to a wide range of people with different amount of capital.

Initially, CFD's only consisted in the difference between the stock price. Today, such contracts are applicable to nearly all market instruments.

Currently, CFD transactions are allowed in such markets as indices, stocks, currencies, cryptocurrencies, and bonds, which you can trade without actually buying or selling stocks or currencies. Instead, you are trading a CFD, a derivative that offers a number of advantages compared to traditional trading.

Introduction to CFD Trading: How It Works

Let's assume you want to buy 1,000 shares of a company stock. You can buy those through an exchange broker paying the total amount (1,000 x current market price per share) and the broker fee. Alternatively, you can buy a CFD for 1,000 shares through a CFD provider, also at the current market price.

This will give you the same exposure, but in order to open such a position you will only need to deposit a margin to cover the possible unsuccessful outcome, as well as a small fee. Selling shares with a CFD broker is easy as well: you just set your contract duration to short term instead of long term, at the bid price. This is why CFD's are usually used by clients who want to hedge their existing investment portfolio.

What Are Margin and Leverage?

CFD is a leverage product, which means you need to deposit only a fraction of its total value in order to open your position. This is called margin requirement. While trading on margin allows you to boost your profit potential, it also magnifies your losses, which are based on the total CFD value.

In other words, you can deposit a small amount of money to manage a much larger position and magnify your possible earnings, but remember that your losses will magnify, too, so you will have to manage your risks appropriately.

Short and Long CFD Portfolios

Acquiring long or short CFD's means betting on the asset price rising or falling. The difference between the long or short CFD is the potential loss or profit obtained from trading.

Taking a long position means buying a security expecting it to appreciate (rise). This is called long because it usually takes a longer period for the markets to go up than to fall. So, in essence, going long just means buying.

Taking a short position means selling a security expecting it to depreciate (fall). As a rule, the markers usually fall much faster and more abruptly than they rise, hence the name. Basically, going long means selling.

What Are the Costs in CFD Trading?

  • Spread: When you are trading CFD's, you have to pay the spread, which is the difference between the ask price and the bid price. When you open a position, you pay the ask price, and when you exit the market, you pay the bid. The less is the difference between these two, the smaller price movement in your favor you will need to be in the money (i.e., earn profit). In Libertex, we always offer competitive spreads.

  • Swap: At the end of each trading day, any position that is carried overnight is subject to the so-called swap, which can be positive or negative depending on your trade direction and the respective interest rate.
  • Commission: When you trade CFD's, you may also be required to pay fees or commissions separately.

For more detailed information on Libertex Trading Terms and Conditions, please click here.

Risks and Rewards

CFD's offer a flexible alternative to traditional investing, and this is why they became popular with a variety of traders. The beginner investors can successfully trade CFD's, but should research this topic first and gain profound knowledge in the risks and rewards involved before risking their money. With an appropriate knowledge base, the traders can use the advantages the CFD's offer at max, while reducing the effect of the disadvantages.

CFD Advantages

Below, you will find a list of advantages of CFD trading that we have complied for your convenience. The investors using a medley of trading strategies will find out that some or all of these factors are compatible with their systems. The list will tell you why so many types of traders use CFD's as a means of speculating in the financial markets.

  • Ability to profit both in rising and falling markets:
    An obvious advantage of CFD trading is that the traders are not limited to only one way of getting profit, such as opening positions in a bullish (rising) market. The ability to trade in both rising and falling markets adds a good deal of flexibility to your trading strategy and allows you to predict the underlying asset prices which may fluctuate both up and down.
  • Position Hedging:
    One of the risk management method used by the investors consists in hedging. For instance, if you have a long position in the stock market which is accumulating losses, you can open a position in the opposite direction through a short CFD. This could seem redundant for some, but this will help you to balance your loss, as if the stock position continues falling, the CFD trade will offer you some gains. Thus, hedging will allow you to limit your risks and avoid future losses.
  • Flexible contract sizes:
    Many CFD traders have an option to choose from a wide range of position sizes that could be compatible with different trading styles of account types. In general, beginner traders are recommended using small lot sizes in order to develop a successful trading strategy that would earn them profit in the long term. More experienced investors may opt for larger exposure in order not to be limited in their trading options.
  • Marginal trading:
    CFD's offer marginal trading, which means a trader has to deposit only a fraction of the total position value. Let's assume you have a short or long CFD position of $1,000. In case the broker margin requirement is 4%, you will need to deposit only $40 to open such a position. The good news here is that, if you are successful, you will get profits from the total size of your position, not just those 4%.

Risks CFD Trading Carries

As any other form of investment, CFD trading does carry risks. You can minimize most of them by appropriately researching this form of investing and sticking to your structured trading plan. However, you should remember there's no way to eliminate the risks completely. The best you can do is reducing the possible negative effects, and to do so you need bear in mind the following.

Over-Leveraged Trading

By far, the biggest error newbies often commit is the decision to risk too much in a single trade. Such 'over-leveraging' occurs every time a beginner trading thinks that CFD's are a way to get rich quickly. So once they get an opportunity to place leveraged positions with an increased profit potential, many of such traders abuse it and suffer substantial losses, which may lead as far as to getting completely broke.

This should not happen in fact, as the above error can be avoided easily. All you need is an appropriate risk management strategy, which will include using stop losses in order to limit your loss size and risking only a small amount of your total account balance. At all times, you should act reasonably in order to achieve a winning streak in the long term instead of trying to make a 'home run' with every single opportunity.

No Right to Vote

Many experienced CFD traders claim that one of the risks in CFD trading is not having the right to vote during the annual board meeting of the company, which is accessible to a regular stock trader. This is important, as after the position is opened, a trader can no longer determine the future policy of the underlying company and thus cannot influence the price direction.

Without influencing the company strategy, CFD traders have to admit that once the position is open, the markets will dictate the price, and the traders will only have to accept the results. This highlights the importance of the price prediction and the trading plan, some of the aspects you should pay maximum attention to.

Conclusion

CFD trading is ideal for the investors that want to get the best from their money.

However, it incurs significant risks and does not suit all investors. We strongly recommend you trading on a demo account first before putting your own money at risk.

CFD trading may be ideal for:

  • People looking for short term opportunities
    CFD's are usually open for a few days or weeks, which is not considered a long term.
  • Those who want to take their own investment decisions
    Libertex only provides order execution services. We do not advise which positions to take and won't trade on your behalf.
  • Those looking to diversify their portfolio
    Libertex offers trading in over 5,000 global markets, which includes stocks, commodities, currencies, and indices.
  • Active or passive traders alike
    You are free to trade as much or as little as you want to.

Our CFD services cover a wide range of asset classes. For more information, please refer to CFD Trading Costs . CFD is a flexible investment vehicle, as the contracts have no expiry date and you decide when you want to liquidate your position obtaining your profit or loss.

We hope you found this article helpful. We invite you to open a free demo account in order to try CFD trading with no risk of loss!

Please don't hesitate to share your questions or ideas in the comments section.

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