A Contract for Difference (CFD) is the difference between where a trade was entered and exited. CFDs are tradable instruments that mirror the price movements of the underlying assets they are tracking. In essence, a Contract for Difference is a binding agreement to exchange the difference in the value of an asset from the time that the contract is opened until the time the contract is closed. It is important to note that Contracts for Difference (CFDs) are derivative assets. Traders do not take physical possession (ownership) of an asset – it is a speculative trade. CFDs can generate profits for the trader when the market moves in your favour (up or down). Profits/losses are possible when the underlying asset moves in relation to the position taken by the trader. There are many advantages to trading CFDs, such as no stamp duty and limited taxes. This makes CFDs an attractive trading proposition for clients.
How a CFD works?
The benefit of trading CFDs is that profits can be realized whether markets are rising or falling. If a trader believes the price of the underlying asset will rise, the trader will take a long position on the asset, by purchasing the underlying asset. Alternatively, if the trader believes that the price of the asset is going to fall, the trader will take a short position on the asset, by selling the asset. Therefore, assets don’t need to appreciate for profits to be realized with CFDs. Unlike other contrarian investment products, the size of the price movement (up or down) is especially important in determining the size of the profit or loss that is generated.
Consider the following example of a CFD:
If you believe Bank of America (BAC) stock will rise, you may be inclined to go long on the stock by purchasing shares of BAC. Assume that Bank of America stock is currently trading at $23.15 per share. If the trader purchases 100 shares at this price, the total cost of this transaction is $2,315. If we were to use a conventional brokerage, a 50% margin may be required, meaning that $1,157 would be needed by the trader. However, with CFD brokerages this is not the case. Typically, just 5% margin is needed so the initial capital outlay for a position comprising 100 shares of BAC stock is $115.75.
BAC stock would be quoted with a 2-way price for each market. The first price is the bid price and the second price is the offer price. The difference between the bid price and the offer price is known as the spread. Here is where it gets interesting: Traders who have a bullish perspective on BAC stock will buy Bank of America at the higher price, and traders who have a bearish perspective of the stock will sell BAC at the lower price. If we were quoting BAC stock, it may look something like this $23.15/$23.75.
- $23.15 is known as the bid price. This is the price the trader can sell Bank of America stock.
- $23.75 is known as the offer price. This is the price that traders can buy Bank of America stock.
Profits and losses are easily calculated by taking the total number of shares traded (how many contracts) of BAC stock and measuring its price movement. Remember that once you enter a CFD trade you will automatically show a loss equivalent to the spread. In this case, it is $0.60. For your BAC position to be at a breakeven point, it will need to appreciate by $0.60. Recall that you purchased 100 shares of BAC stock at $23.15 per share for a total transaction value of $2,315. If the stock appreciates to $23.75, the conventional profit is $60 on 100 shares. That translates into 5.2% profit. However, the CFD bid price at that point may only be $23.73 ($0.02 less). In this case, the profit that is generated is $58 (100 shares x $0.58). As a return on investment, the percentage is 50.1%. It is evident that owing to the low margin requirement, the profit percentage is significantly higher with CFD trading, despite the trader being required to purchase at a higher initial price than a conventional stock.
Advantages of CFD trading
- There are no day trading requirements with CFD trades. Traders can open accounts for as little as $500 or less in some cases, although much larger deposits can easily be made.
- CFD brokerages do not charge fees, and if they do they are minimal. The way brokerages make their money is by the spread. To purchase a CFD, traders must pay the asking price and to sell the CFD, the traders must take the bid price. Typically, there are fixed spreads.
- CFDs are highly leveraged products, meaning that the minimum margin requirement is really low (2% in some cases). Lower margins mean less capital outlay is needed to open large positions.
- CFD trading allows for global market access from a single platform.
- There are no stamp duties in the United Kingdom since no assets are actually owned.
Disadvantages of CFD trading
- CFDs are highly leveraged products, and losses can be magnified.
- Since there are spreads on entering/exiting trades, small price movements can virtually eliminate profits.
- Not all CFD brokerages are fully licensed and regulated.
From a trading perspective, it makes sense to consider CFDs. Lower margin requirements mean that it is possible to trade CFDs with ease. Profits can be generated on rising or falling markets, provided the trader calls it correctly. This size of the price movement directly affects the profits or losses that are generated. It is important to consider CFD brokers with low spreads, since spreads can eat up profits when assets only move slightly in price. The absence of fees and commissions make CFDs attractive over conventional investments, but unattractive spreads can act as a counterbalance to many of those benefits.