What is a contract for difference (CFD)?

What is a contract for difference (CFD)?


Contracts for Difference (CFD) are popular albeit specialist financial derivative products that allow you to trade on the price movements of financial assets, Futures Indices, Commodity Futures, Cryptocurrency, Stocks and Exchange Funds.

09 Aug 2018

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?

Margin

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.

Benefits and risks

CFDs offer a flexible alternative to traditional investment and therefore represent an attractive instrument for a wide variety of traders. It is possible for beginners to trade CFDs successfully, but they must first do thorough research into the benefits and risks involved before using real money.

With proper preparation, traders can take full advantage of many of the positive aspects of CFDs, while simultaneously minimising the potential drawbacks.

Advantages of CFDs

Trader workplace

We have compiled a list of the main advantages typically associated with CFD trading. Investors who use a wide variety of trading strategies will find some or all of these techniques are compatible with their methods. Once you have read our list, it will become clear why so many different types of traders use CFDs to speculate on the financial markets.

  • Ability to achieve profits in both up and downtrending markets

A clear advantage of CFD trading is that traders do not limit themselves to positions in a single type of economic environment (e.g. buy positions in an uptrending market). The ability to trade in both bull and bear markets adds flexibility to your trading strategy and allows you to forecast price movements that match underlying fundamentals (which can fluctuate both up and down).

  • Ability to cover positions

One method that investors use to minimise their potential risk is the implementation of "covered" positions. For example, if you have a long position in shares and it's accumulating losses, you can open a position in the opposite direction using a short CFD. This may seem a bit boring to some, but it will certainly help to balance losses as the short position will start to generate a profit if prices continue down. This balance, or "coverage", will allow you to limit your risk and avoid future losses.

  • Flexible contract sizes

Many CFD traders have a variety of trade sizes at their disposal which they can use for various trading styles or investment account types. As a general rule, beginners want to limit themselves to smaller-sized lots until they have developed a successful trading strategy that generates sustained, long-term profits. Experienced investors may opt to risk more money to avoid feeling limited in their trading structure.

  • Trading margin

Margin trades are usually allowed for CFDs, which means that traders are only required to deposit a portion of the actual transaction size for each trade. For example, let's suppose you have a CFD trade on shares worth $1,000 (either short or long position). If your broker's margin requirement is 4%, this means that you only need $40 to open the position. The positive side of this is that you will receive all the profits gained from the entire exchange (not just 4% of the value earned).

Risks involved in CFD trading

Like anything in life, CFD trading is not without its risks. Most of these potential negative effects can be reduced with proper research and by following a structured trading plan. But you must remember that there is no way to completely eliminate all risk. The best we can hope for is to minimise the possible negative effects. With this in mind, we recommend you take note of the following potential pitfalls:

 Over-leveraging of positions
Far and away the biggest mistake that new traders can make is risking too much on a given position. One of the reasons "over-leveraging" occurs so frequently with inexperienced traders is that many of them look at CFD trading as a new career and a path to wealth. When given the chance to place leveraged trades (with the potential for improved earnings), many new traders abuse this opportunity and incur significant losses (or even completely wipe out their trading accounts) in the process.

Now, this shouldn't be cause for discouragement since this error is easily avoided.

All you need is an appropriate risk management strategy: use stop orders to limit the size of your losses and risk only a manageable proportion of your trading capital.

Traders must remember to be prudent at all times as they aim to create a base of CFDs that generate steady, long-term profits, instead of trying to hit a perfect "hole-in-one" at every opportunity.

 CFDs confer no voting rights
Many experienced CFD traders argue that there is an additional risk inherent to CFD trading in that this asset does not confer voting rights at the underlying company's Annual General Meeting or any other meetings of the company as would be enjoyed by a normal shareholder. This is significant since, once a position is opened, the trader has no say in any of the underlying company's future policy decisions. The trader is essentially a spectator with no power to influence price movements.

Once a position is open, the markets will dictate prices and traders must accept the results passively as they are powerless to influence the behaviour or strategy of the company. This only goes to show the importance of accurate forecasting and solid trading plans, so be sure to pay special attention to this aspect of CFD trading.

Conclusion

CFD trading is ideal for investors looking to improve their yields.

Nevertheless, it entails significant capital risks and is not suitable for everyone. We strongly recommend trading with a demo account before trying with your own money.

CFD trading may be ideal for the following categories of potential investors:

  • Those looking for short term opportunities
    CFDs are generally kept open no longer than a few days or weeks.
  • Those who want to make their own investment decisions
    Libertex provides brokerage services only. We will not advise you on what options to trade and we will not trade on your behalf.
  • Those looking to diversify their portfolio
    Libertex's trading offering includes assets from more than 5,000 global markets and comprises stocks, commodities, currencies and indices
  • Those who wish to trade as little or as much as they want
    You can trade as often or as infrequently as you like.

Our CFD service covers a wide range of asset classes. Find more information on CFD trading fees here. CFDs are flexible investment vehicles. As contracts with no maturity date, you decide exactly when you want to close your position and realise your profit or loss.

We hope this article has been of use to you. You may open a free demo account  anytime you feel ready to try and trade CFDs on your own. Go on! What have you got to lose?

We would also appreciate it if you would share any questions and suggestions you may have in the comments section.

Libertex is an international brand with twenty years of experience in financial markets and online trading. Since 1997, Libertex has been helping investors trade stocks, currencies, indices, commodities, gold, oil, gas and other various financial instruments as effectively as possible. Libertex provides first class service to more than 2,200,000 clients across Latin America, Europe and Asia.  Libertex's offering includes 150 different trade instruments.  Libertex was named Best Trading Application in the Eurasia Economic Union 2016 by the prestigious Global Banking & Finance Review, a leading online financial publication.

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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