What Is A Cfd?
CFD is an acronym for Contract for Difference, a financial derivative. A CFD is exactly what its name would suggest and constitutes a contract struck between a buyer (a trader) and seller (a market maker or direct match in the wider market) on the difference in price of a financial instrument between the start and end of the contract. One of the two parties involved in the contract commits to pay the price difference to the other if it rises between the open and close of the agreement, and the other if it falls.
The contract also involves leverage so the price difference is multiplied by a factor which can range from x5 to x-several hundred, though for retail investors this is capped at a maximum of x50 in many territories. Institutional CFDs traders, or high net worth individuals who prove they have the funds and experience to use higher leverage responsibly, can use higher multiples. This means that traders can open CFDs positions of far higher value than that of the margin they need to deposit.
CFDs can be used to take both short and long positions while the broker takes a small spread, or commission, on the value of each CFD. The flexibility of CFDs and the relatively low transaction costs involved, compared to taking ownership of the underlying asset whose price the contract is on, has led to them becoming very popular with both investment and retail traders and investors.
CFD trades generally do not expire automatically. When the trader decides to close a position, either to limit their loss if price direction has moved against them, or lock in profits, a CFDs position in the opposite direction is taken. If a long position has been taken on a CFD for 100 shares in ‘company X’, and the price then, contrary to the trader’s expectations, starts to fall and the trader doesn’t want to risk it falling further, increasing the loss, then they will sell a CDF for 100 shares in ‘company X’. This closes the position and locks in the loss. A profit would be locked-in in the same way.
Company X has a share price of $100. The CFDs trader believes this will fall so he/she takes a short CFDs contract on the share price. The trader wants to use the leverage of 1:10 so he/she puts down $1000 as the ‘margin’ on a CFDs position worth $10,000. Over the course of a few days, as expected, the share price of company X drops 5% to $95. The trader is not sure if or by how much the price will continue to drop so he/she decides to lock in the profit by taking the opposite trade, effectively closing the position. The 5% difference between the share price at the opening and close of the CFDs is $50. The 1:10 leverage that was part of the contract means that the trader, in this case, takes a profit of $500 on the $1000 margin put down.
If the share price of company X had, instead, risen by 5% before the trader closed the CFDs position, they would have lost $500 of the $1000 margin put down.