What is a CFD?

Posted By Robert On Friday, February 6th, 2015 With 0 Comments

The CFD (or Contract For Difference) is a hugely popular method of trading the financial markets and is also used by many investors to hedge against stock positions they hold.

CFD means Contract for difference. It is a contract between two parties a buyer and a seller, which stipulates that the seller will pay a buyer the difference between the current value of an asset and its value on the expiry date. If the difference is negative, the buyer must pay the seller. CFDs are equity derivatives that allow investors to speculate on price movements, without having to own the underlying asset.

“A contract for difference (CFD) is a contract between two parties in which one pays to the other a sum of money based on the difference between the current value of a security or instrument and its value on a specified future date. If the difference is the opposite of that specified in the contract i.e. it is negative not positive, payment is made in the opposite direction.”

CFD trading allows you to back your judgement as to whether you think a financial instrument will go up or down in value.

When you trade CFDs you’re essentially speculating on the future price of the underlying asset, unlike traditional shares trading you don’t physically own the asset.

Defined a different way, a contract for difference is an agreement to exchange the difference in value of a financial instrument between the time at which it is opened and the time at which it is closed. Your profit or loss is determined by the difference between the price you buy at to the price you sell at, multiplied by the amount of contracts you hold of course.

Contract for differences or CFDs explained:

Contracts for difference, or CFDs, are becoming the world’s most rapidly growing trading tool since their inception in the 1990s. CFDs are a contract between a buyer and a seller speculating the movement of an asset price. So, if you buy a CFD, you agree to exchange the difference in value of a particular share between the time at which the contract is opened and the time at which it is closed. If the share rises in price, the buyer receives cash from the seller, and vice versa.

For Instance:

If you buy a contract for difference at £10 and sell it for £12 then you will receive the £2 pound difference. If however, you buy the CFD for £10 and sell it for £8 then you must pay the £2 difference.

Please note that CFDs are leveraged products that carry a high degree of risk and it is possible to lose your entire investment (i.e. your total account balance).

Let’s use another example:

Shares in company ABC are trading at 280-281.

If a trader wanted to buy a 20,000 shares contract at £2.81 per share, the total value of the contract would be £56,200.  Working on a 1% margin requirement, they might only need to hold £562 in their account to open this contract.  If the value of these shares rallied to 310 (£3.10) then they could close the contract at the sell price of £2.80 having made a profit of 30p per share (310-280).  The total value of the gain would be 20,000 shares x  30p = £6000.

A trader that trades CFDs is able not only bet on the price increasing (going long) but also on it decreasing.  Those that speculate on the price declining are knows to be going short. Using the figures above, if a trader did in fact decide to sell a contract of 20,000 shares at 280, and the price dropped to 200p, they would have made a profit of 16,000 (280 – 200 = 80 x 20,000)

Please note:  The calculation above is slightly off as the buy/sell prices would have moved in line with the change in share price.

How do I Begin Trading CFDs?

If you have never used derivatives before then we would highly recommend you begin by reading through each of the guides on this website to improve your knowledge.

The next step would be to open a demo account with one of the more reputable brokers such as Ayondo.  A demo account will allow you to trade, for free, in a risk free environment using ‘play’ money.  When you are ready to begin trading for real, you will probably want to begin with a small deposit to see how successful you are.

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