CFD stands for “Contract for Difference”
A CFD is an agreement between two parties (a buyer and seller) for the buyer to pay the seller the difference between an asset’s current market value and the asset’s expiry value (future valuation at the time the contract matures or expires) without the actual physical exchange of the asset from seller to buyer. A CFD can equally be described as a contract where the settlement is made through cash payments based on the difference between the market value at initiation of the contract and the value of the asset on expiration of the contract.
In other words, CFD contracts allow traders to take positions on assets without actually owning the asset. However, all benefits and risks associated with actually owning the asset are enjoyed by the traders of the asset.
How a typical CFD trade is made
The trade illustration below shows how a CFD trade is made. For this example, we use a fictional trader named John, who decides to trade a short position on the stock of YZA company in order to profit from disappointing earnings results.
John decides to short 10,000 shares of YZA at a price of $10.50 a share. Therefore, John’s leveraged position is worth $105,000 (10,000 X 10.50).
The leverage for the trade is 1:10, so John is only expected to come up with one-tenth of the cost of the acquisition, which is $10,500.
The price of the stock falls to $10 a share. John’s profit will therefore be:
10,000 shares (10.5 – 10.0) = 10,000 X 0.5) = $5,000
So John’s investment of $10,500 has earned him a profit of $5,000. This is how a trader can profit from a CFD trade. Also notice how the leverage was able to allow John to make a tidy profit relative to his investment.
What makes up CFDs?
In the financial markets, CFDs can be traded on a variety of instruments spanning several asset classes: stocks, commodities, currencies and indices. These are all assets that have a bid price and an ask price, are traded in contracts and are all leveraged.
A CFD trade must have the following characteristics:
- Such trades can be traded with leverage, which means that a trader can hold large positions with a small amount of money, equivalent to the size of leverage provided by the broker.
- A CFD trade does not involve direct trading of the underlying asset, and there is no physical exchange of the underlying stock, commodity or currency.
- CFDs do not have expiry dates, which is unlike options trades.
- CFDs are rolled forward and carried over to the next day, attracting interest. The interest can be debited from the trader’s account or credited to same, depending on which direction the trader’s CFD position is in. Thus CFD trades can be kept open as long as the trader has enough margin to cover the position.
- Traders can trade on both the long and short side of the market.
- The price action of a CFD trade directly mirrors the price action of the underlying asset.
- There are no restrictions to the entry or exit prices of the CFD instrument.
- CFD conditions are not standardized. Therefore, only a broker can provide the conditions under which a CFD asset is traded.
The same trade can be done as a short sell, so if the share price drops the CFD trader can profit from the falling price.
Advantages of CFDs
Trading CFDs carry a number of advantages. These are listed below:
- Traders can trade CFDs online on a variety of instruments. So opening an account with a CFD broker allows the trader to get great variety on what to trade and how to trade.
- CFD trading can be performed from one single platform. There is therefore no need to open a separate account for stock trading, currency trading and commodities trading.
- Trades can be kept open for as long as possible.
Disadvantages of CFDs
- Traders can potentially lose more than what was invested in the original trade, especially under conditions of excessive slippage.
- CFDs require the trader to commit more margin to the trades as leverage is usually lower.
Despite the disadvantages, CFD trading can be a profitable venture when approached in the right way. AG Markets provides traders with the opportunity to trade CFDs on several assets.