What is a Contract for Difference – Ultimate Guide on CFDs

what is a contract for difference

It is a Saturday morning, and I am here at my home office wondering, what exactly are contracts for difference or CFDs?

This is a term I wanted to understand and therefore did some research.

A Contract for Difference (CFD) refers to a contract that enables two parties to enter into an agreement to trade on financial instruments based on the price difference between the entry prices and closing prices.

A contract for difference, popularly known as a CFD, is an advanced trading strategy where an arrangement is made in the financial derivatives trading.

In this strategy, the differences in the settlement between the open and closing trade prices are cash-settled.

There usually is no delivery of physical assets or securities.

Understanding this is important in your journey as a trader. You will find that CFDs will provide you with great benefits.

What do contracts of difference achieve?

In my research on the contracts for difference, it becomes clear that CFDs have several benefits to you as a trader. Some of these benefits include;

This financial contract helps you to pay the differences in the settlement price between the open and closing trades.

CFDs will allow you to trade the direction of financial securities over the short-term. They are very popular in the forex trading (FX) as well as in the commodity trading market.

Contracts for difference are paid using cash but usually allow margin trading. This is important to you as an investor as you need to only put up a small amount of the contract’s notional payoff.

How does a contract for difference work?

In other financial instruments like stocks/shares and bonds, the traders must physically own the securities or the financial assets.

With regard to CFDs, the traders do not hold any tangible asset. Instead, they trade on margin with units that are attached to a given financial security’s price. This depends on the market value of the security being traded.

Therefore, a contract for difference is effectively the right to speculate on the changes in the price of a security without having to actually purchase the security.

The name of this investment explains what it is a contract. It is going to help you profit from the difference in the price of a security between the opening and the closing of the contract.

How do Contract for Difference provider’s make money

Until now, we have seen how traders’ profit from CFDs. However, how do CFD providers make their living?

The way CFD providers make money is through:

  • Spreads.
  • Commissions.
  • Financing.
  • Hedging.

Advantages of CFDs?

Advantages of a Contract for Difference

Contracts for difference provide the traders with a number of advantages, and let us try to discuss them below;

As noted, with a CFD, you get the benefits and risks of owning a security or asset without actually owning it or having to take the physical delivery of the asset.

Since contracts for difference are traded on margin, the broker will allow you to borrow money to increase leverage or the size of the position. This will end up increasing the potential for your gains as an investor.

In order for you to do this kind of a transaction, your investment broker might require you to maintain a certain balance in your trading account.

Trading on margin CFDs typically provides higher leverage than traditional trading.

Standard leverage in the CFD market can be as low as a 2% margin requirement and as high as a 20% margin.

Lower margin requirements mean less capital outlay and greater potential returns for the trader.

Typically, fewer rules and regulations surround the CFD market as compared to standard exchanges.

As a result, CFDs can have lower capital requirements or cash required in a brokerage account.

Benefits of a Contracts of a Difference

Often, traders can open an account for as little as $1,000 with a broker. Also, since CFDs mirror corporate actions taking place, as a trader, you can receive cash dividends increasing your return on investment.

Most CFD brokers offer products in all major markets worldwide, which mean that you have easy access to any market that is open from the broker’s platform.

CFDs allow investors to easily take a long or short position or a buy and sell position. The CFD market typically does not have short-selling rules. An instrument may be shorted at any time.

Since there is no ownership of the underlying asset, there is no borrowing or shorting cost.

Also, few or no fees are charged for trading a CFD. Brokers make money from the trader paying the spread meaning the trader pays the ask price when buying, and takes the bid price when selling or shorting.

The brokers take a piece or spread on each bid and ask price that they quote.

Disadvantages of a Contract of Difference

If the underlying asset experiences extreme volatility or price fluctuations, the spread on the bid and ask prices can be significant.

Paying a large spread on entries and exits prevents profiting from small moves in CFDs decreasing the number of winning trades while increasing losses.

Since the CFD industry is not highly regulated, the broker’s credibility is based on its reputation and financial viability. As a result, CFDs are not available in the United States.

Since CFDs trade using leverage, investors are holding a losing position can get a margin call from their broker, which requires additional funds to balance out the losing position.

Although leverage can amplify gains with CFDs, leverage can also magnify losses and traders are at risk of losing 100% of their investment. Also, if you borrow money from a broker to trade, the trader will be charged a daily interest rate amount.

Conclusion

Today, being able to make an extra income is very important. You might have lost your job and are seeking for opportunities to make an income.

One way this can be done is through trading in stocks or in financial assets.

Understanding this is important in your journey as a trader. You will find that CFDs will provide you with great benefits. CFDs are interesting and are increasingly becoming popular amongst the trading community.

For all the convenience that a CFD provides a trader with, CFD providers or brokers also make their money from the trading that the traders carry out with CFDs.

Yet the CFD brokers are always looking for innovative ways to make money.

Frequently Asked Questions

What does contract for difference mean?

A contract for differences (CFD) is a financial arrangement. In this case, it is trading where the differences in the settlement between the open and closing trade prices gets paid in cash.

As mentioned above, there is no delivery of physical goods or securities with CFDs

How long can I hold a CFD?

CFDs do not expire so a trader can hold both short and long position as much as he can fund the position.

However, long CFDs starts to get expensive after 4-6 weeks as they levy financing charges.

Therefore CFDs are not good for long term investing. CFDs are best for short term trading and speculation of the market.

What is a contract for difference energy?

CfD is a long-term contract between an electricity generator and Low Carbon Contracts Company (LCCC).

The contract enables the generator to stabilise its revenues at a pre-agreed level (the Strike Price) for the duration of the contract. Under the CfD, payments can flow from LCCC to the generator, and vice versa.

Why are CFDs not in the US?

CFDs are illegal in part because they are an over-the-counter (OTC) product – not passing through regulated exchanges.

Most FCA regulated brokers, for example, do not allow USA citizens to open an online CFD trading account.

Non-US citizens, however, can trade CFDs on American shares and markets.

Where does CFD money come from?

One of the ways that CFD’s make money is from spreads. Spreads are always inclusive of a CFD provider’s fee.

While giving the trader the final price to buy in, the included fee is what makes the price a little costlier.

Hence, with every buy that a trader makes, CFD providers take their profits.