What is CFD?

A contract for differences (CFD) is an advanced trading strategy used by experienced traders and it is not allowed in the United States. In simple terms, CFD is when you enter a contract to trade the speculative value of an underlying asset. This means that the CFD contract does not make the traders owners of the underlying assets and does not deliver any physical good or assets. Instead, it gives them the ability to speculative on its value whether it will go up or down.

Summary of CFD

  • A CFD is a contract that pays for price differences. This difference is between the initial price and the final price when trading.
  • They are suitable for trading in the short term when investors trade the direction of the movement of securities prices.
  • Price differences realized with CFD, traders receive in cash on their account. 
  • The use of CFDs involves trading the margin that the broker requires. It means that traders have to pay a certain, not large amount, assumed contractual payments.


How CFDs work?

CFDs are derivatives. Derivatives are financial instruments that are derived from the value of an underlying asset. Traders that expect the price of an asset to go up will place a buy position on the CFD, while those who expect a fall in the price will sell the CFD. The reason CFDs are different is because you can place a sell position even if you do not own the stocks. This is not the case when you invest in the stocks and not the derivatives.


CFD – The net difference

When a trader who has bought a CFD sees the price of a stock or asset rising, he will offer it for sale. The difference, thus realized, is the net difference. The net difference, which can be a profit and someone’s loss, is settled through the broker’s account of the trader. Remember in order for an order to be completed there must always be someone else on the other side. This is why someone will leave with profits and the other one with losses.

When the price drops

There may be a situation where the trader feels that the price of the security or assets will fall. Then, he offers the starting price of that security for sale. In the closed position, the trader buys an offsetting trade. And the net difference, both gain or loss, obtained in this way is settled through the investor’s brokerage account.

Futures Contracts

In addition to trading securities and assets, contracts for differences can also be useful for exchange-traded funds (ETF). Traders will calculate and speculate on the prices of these funds as well and predict price movements in commodity futures contracts. These goods can be any traded goods, such as crude oil, corn, etc. Futures contracts are nothing but agreements with obligations according to which there is an obligation to buy or sell an asset, goods at a predetermined price with a future expiration date.

You should note a distinction between CFDs and futures. CFDs allow traders to speculate, predict, and trade futures prices, but CFDs as such are not futures. CFDs do not have an expiration date like futures contracts do. They do not even have pre-set prices CFDs trade like other stocks and securities, according to purchase or sale prices, depending on the trend.

CFD is not traded on major stock exchanges

Contracts for Differences are traded, through a brokerage network. Brokers organize demand and supply, which determines the prices of CFDs. It means that CFDs trade over the counter (OTC). It again means that CFDs are not traded on major world stock exchanges. A CFD is a contract that a broker, through a network, has entered into with a client. Thus, the broker and the client exchange the difference in the price. It means the difference between the opening price of trading and the value of the price after the reversal or other changes in the market.

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What is the purpose of CFD?

They enable traders to reap the benefits as well as to bear the risk that the securities themselves entail. But, the difference is that traders do not have to own that securities or have to deliver any asset. For traders to participate in such trade, they will have to have a certain balance in their accounts. It is because CFDs are traded on a margin, and thus the broker allows traders to borrow money for the best possible position to make a profit. That is why it is necessary to maintain a balance on the accounts before brokers allow traders such transactions.

When is a contract for differences trading better than a traditional one?

It is better because it provides more leverage than the well-known stock market trading. Trading CFDs can mean a low margin requirement of 2% as well as a high margin of 20%. Lower margins allow for lower capital expenditures with potentially higher earnings for the trader. Also, there are fewer rules on the CFD market than standard stock exchanges. All this, as a benefit, means a lower level of cash in the account required for trading. The account required to trade on a CFD can be as much as $ 1,000 for brokers to accept a trader.

Spread instead of fees

In the CFD market, it is often the rule that there are no short-selling rules. Also, this market allows traders to take any of the positions, sales, buying, short-term or long-term. There is also no cost associated with borrowing or shortening because there is no ownership of the underlying asset. There are no fees for participation in the trade in this market, or they are lower.

Broker earnings come from spreads. It means that the trader pays the asking price when buying and takes the offered (bid) price when selling. Brokers take a spread, which is also called peace, for each offer and ask for a quoted price. Disadvantages of the CFD market

If the price of an underlying asset has high volatility in a certain period, the spread, in that case, can be large. It means that the range between the bid and ask is significant. Paying a large spread for small CFD moves does not bring a lot of money. Thus, the number of successful trades decreases, which in turn affects the increase in losses. 

The regulation of the CFD market is not on a high level, so you are left to believe in the credibility of the broker. It depends on his reputation and financial viability. It is also the reason why CFD is not present in the US.

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Leverage can be another disadvantage

For traders who have a good position, leverage can increase profits with CFDs. However, since CFDs trade using leverage, it can also mean a great loss for traders. It happens when traders are in a losing position. Then they can get a margin call from the broker, which means an extra deposit to balance their losing position. It can lead to a loss of as much as 100% of trade investment. And more, if a trader borrows money from a broker to trade, he pays interest, according to the daily rate.

Example of contract for differences

Let’s see what it looks like in the following example. A trader wants to buy a CFD on a fund that can be traded on the stock exchange. The broker will ask the trader for a certain percentage, say 5%. The trader will buy 100 shares for $ 300 each and thus has a position of $ 30,000. From that position, the trader pays the broker the mentioned 5%, which is $ 1500. 

After a while, the share rises to $ 350, and the trader decides to leave the position. It means that the trader made a profit of $ 50 per share, which is a total of $ 5000. The difference between the initial and closing position is gain for the trader. That difference, in this case, $5000, is cashed to the investor on his account. 

Contract for differences – Conclusion

With the help of CFD, traders can trade the movement of asset prices, funds (ETFs), futures goods, where traders do not have to own the same commodity funds, etc. They can also use leverage and so with a small percentage of trading to the broker. It is possible to take any of the positions, long, short, selling, buying. 

However, you should bear in mind that leverage can be risky and mean loss. Also, pay attention to price volatility and the consequent large spread between the broker’s offered price at which the trader buys and the selling price. Always check the credibility of the broker and the reputation he has. And be prepared if you are in a losing position to get a margin call from a broker, which means you will have an extra deposit.