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Contract for Differences (CFD)
What Is a Contract for Differences (CFD)?
A contract for differences (CFD) is an arrangement made in financial derivatives trading where the differences in the settlement between the open and closing trade prices are cash-settled. There is no delivery of physical goods or securities with CFDs.
Contracts for differences is an advanced trading strategy that is used by experienced traders and is not allowed in the United States.
- A contract for differences (CFD) is a financial contract that pays the differences in the settlement price between the open and closing trades.
- CFDs essentially allow investors to trade the direction of securities over the very short-term and are especially popular in FX and commodities products.
- CFDs are cash-settled but use allow ample margin trading so that investors need only put up a small amount of the contract’s notional payoff.
Understanding Contract for Differences
CFDs allow traders to trade in the price movement of securities and derivatives. Derivatives are financial investments that are derived from an underlying asset. Essentially, CFDs are used by investors to make price bets as to whether the price of the underlying asset or security will rise or fall.
CFD traders may bet on the price moving up or downward. Traders who expect an upward movement in price will buy the CFD, while those who see the opposite downward movement will sell an opening position.
Should the buyer of a CFD see the asset’s price rise, they will offer their holding for sale. The net difference between the purchase price and the sale price are netted together. The net difference representing the gain or loss from the trades is settled through the investor’s brokerage account.
Conversely, if a trader believes a security’s price will decline, an opening sell position can be placed. To close the position they must purchase an offsetting trade. Again, the net difference of the gain or loss is cash-settled through their account.
Contract for Differences (CFD)
Transacting in CDFs
Contracts for differences can be used to trade many assets and securities including exchange-traded funds (ETFs). Traders will also use these products to speculate on the price moves in commodity futures contracts such as those for crude oil and corn. Futures contracts are standardized agreements or contracts with obligations to buy or sell a particular asset at a preset price with a future expiration date.
Although CFDs allow investors to trade the price movements of futures, they are not futures contracts by themselves. CFDs do not have expiration dates containing preset prices but trade like other securities with buy and sell prices.
CFDs trade over-the-counter (OTC) through a network of brokers that organize the market demand and supply for CFDs and make prices accordingly. In other words, CFDs are not traded on major exchanges such as the New York Stock Exchange (NYSE). The CFD is a tradable contract between a client and the broker, who are exchanging the difference in the initial price of the trade and its value when the trade is unwound or reversed.
Advantages of a CFD
CFDs provide traders with all of the benefits and risks of owning a security without actually owning it or having to take any physical delivery of the asset.
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CFDs are traded on margin meaning the broker allows investors to borrow money to increase leverage or the size of the position to amply gains. Brokers will require traders to maintain specific account balances before they allow this type of transaction.
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. Often, traders can open an account for as little as $1,000 with a broker. Also, since CFDs mirror corporate actions taking place, a CFD owner can receive cash dividends increasing the trader’s return on investment. Most CFD brokers offer products in all major markets worldwide. Traders 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 CFD
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 holding a losing position can get a margin call from their broker, which requires additional funds to be deposited 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 money is borrowed from a broker to trade, the trader will be charged a daily interest rate amount.
CFDs allow investors to trade the price movement of assets including ETFs, stock indices, and commodity futures.
CFDs provide investors with all of the benefits and risks of owning a security without actually owning it.
CFDs use leverage allowing investors to put up a small percentage of the trade amount with a broker.
CFDs allow investors to easily take a long or short position or a buy and sell position.
Although leverage can amplify gains with CFDs, leverage can also magnify losses.
Extreme price volatility or fluctuations can lead to wide spreads between the bid (buy) and ask (sell) prices from a broker.
The CFD industry is not highly regulated, not allowed in the U.S., and traders are reliant on a broker’s credibility and reputation.
Investors holding a losing position can get a margin call from their broker requiring the deposit of additional funds.
Real-World Example of a CFD
An investor wants to buy a CFD on the SPDR S&P 500 (SPY), which is an exchange traded fund that tracks the S&P 500 Index. The broker requires 5% down for the trade.
The investor buys 100 shares of the SPY for $250 per share for a $25,000 position from which only 5% or $1,250 is paid initially to the broker.
Two months later the SPY is trading at $300 per share, and the trader exits the position with a profit of $50 per share or $5,000 in total.
The CFD is cash-settled; the initial position of $25,000 and the closing position of $30,000 ($300 * 100 shares) are netted out, and the gain of $5,000 is credited to the investor’s account.
Forex or CFD — Where Should I Start?
Traders should understand that there is no better market, as forex and CFD’s, although similar are very different when compared.
Forex and CFD trading might seem similar and traders can often confuse themselves in figuring out which is a better market to start trading.
At the outset, traders should understand that there is no better market, as forex and CFD’s, although similar are very different when compared. As a trader, the first step is to understand your risk profile and your initial capital that you would like to start trading with.
For someone trading with $500, it is best to stick to the forex markets while for others who have larger capital amounts to trade with, CFD’s can also be traded. The bottom line is that both the markets (forex and CFD’s) are volatile and uncertain and there is no unique advantage or an edge that a trader gets if they opt for one market over the other.
Similarities and Differences between Forex and CFD Trading
CFDs and forex are quite similar considering that the transactions are executed over-the-counter (OTC). Whether you want to trade CFD’s or Forex, you can trade in both rising and falling markets, meaning that you can buy (go long) as well as sell (short) the markets.
Trades are executed on the same platform and are processed electronically through the network of banks and not at a centralized exchange. CFDs and forex also carry similar transaction costs, which could be a commission on the trade or the spread as well as the overnight rollover swaps.
Whether you want to trade CFD’s or forex, the fact remains that the trades do not entitle you to any sort of actual ownership of the underlying security that is being traded. For example, if you were trading the EURUSD, you do not own the euros, but merely speculate on whether the euro will rise or fall, relative to the US dollar.
Similarly, if you were trading a commodity CFD such as oil, you do not actually own a barrel of oil. With the similarities between CFD’s and forex covered, the obvious question is what sets them apart.
The biggest difference between a CFD and a forex contract is the fact that CFD’s cover a diverse range of markets. While forex is limited to the currency markets, CFD contracts can range from a stock CFD, commodity CFD or indices CFD.
Based on the contract being chosen for CFD trading, you can expect variations in terms of the minimum tick size, the base currency and the lot size as well. With forex, the lot size is uniform regardless of whether you trade EURUSD or USDCAD.
On the fundamental aspect, the price fluctuations in a CFD contract depend on the markets. For example trading a CFD for indices such as the German DAX is influenced by the respective stocks in the index, earnings and so on. With forex, the fundamental aspects that determine the currency’s movement is based on economic factors and global macroeconomic events.
How Does CFD Trading Work?
The best way to understand how CFD trading works is to start with an example of a stock:
If a stock is trading at $50 and you purchased 100 shares, your initial cost of the transaction amounts to $5,000 (100 shares x $50).
Now, when you trade on margin, say 50%, your transaction cost now comes to only $2500. If you were to trade the same stock via CFD’s which require only a 10% margin, your equity investment now comes to only $500.
CFD stock trading specifications
The above example shows Alcoa’s shares.
- We know that 1 lot equals 2000 shares
- Alcoa is currently trading at $10
- If you were to trade through an exchange broker, you would require capital of 2000 x $10 = $20,000
- With a 20% margin, your equity investment would come to 2000/20 * $10 = $1000
Note that besides the margin, there is a negative swap of $2 that is applied to long or short positions in Alcoa.
With CFD’s, although the transaction costs are lower you still need to pay the spread. Therefore, if the spread was 5, then your CFD transaction opens with a loss equal to the spread.
In order to realize a profit, the stock needs to move a minimum of 5 cents to initially break even on your trade and then realize some profits. Some brokers charge a commission on CFD transactions as well.
The above example illustrates the point that CFD trading is ideal if you want to trade an instrument that would typically require a higher equity investment. Therefore, a stock trader could trade CFD’s lowering their equity costs rather than owning the shares.
Also, with CFD trading, because you do not own the shares, it is more suited for speculative trading rather than investing.
Besides, the spread, CFD contracts also come with rollover or overnight swaps which are determined by the broker. CFD contracts are also subject to dividend payouts.
Therefore, if you were long on a CFD contract for a stock and the company announced dividends, that amount would be credited to your long position. However, if you were short on a stock and the dividends were paid out, that amount is deducted from your position.
- CFD trading makes it possible to trade a security that would typically require higher transaction costs
- With CFD trading, you do not own shares or the security that you are trading
- Lower margin requirements and the ability to go long or short on CFD contracts makes it easy to profit from both rising and falling markets
- CFD trading comes with additional costs such as spreads and rollovers or swaps
- With CFD trading, the transaction sizes can vary. A 1 Lot trade for Alcoa for example, buys you 2000 shares, but on the other hand, 1 Lot trade for ZYNGA buys you 1 share. Traders should bear the lot sizes and their respective share sizes when trading with CFD contracts
CFD Trading – Varying Contract Sizes per 1 Lot
How Does Forex Trading Work?
Forex trading is a lot more straightforward compared to CFD trading. For starters, you can trade from as little as 0.01 lot or 1000 contracts. With forex, when you trade a currency pair, you are essentially buying one currency and selling the other.
So a long position in EURUSD means that you are buying euros and selling dollars. With forex, the margin requirements are far less compared to CFD trading contract specifications.
The picture below shows an example of a EURUSD position. 1 lot equals $100,000 units. So a long EURUSD position for 1 lot infers that you are selling 100,000 US dollars. The margin size requirement for a 1 lot transaction requires 200% margin.
Therefore, if you bought EURUSD at 1.12826, your actual transaction size would amount to 100,000/200 * $1.12826 = $564.13.
With forex, the lot size remains the same, which is 100,000 units of the base currency that you are buying or selling.
Forex – Contract Specification
- With forex trading, you are focusing on just the currency markets
- Forex trading allows you to trade from as little as 1000 units in lot sizes thus making it easy for traders with lower capital to trade these markets
- Forex trading is subject to the respective currency’s economies and global developments and traders should always keep an eye on the unfolding events
- Forex contracts are also subject to rollover swaps which vary on long and short positions as well as the currency pairs in question.
In conclusion, whether you want to trade CFD or forex, the choice is entirely up to the trader. To best determine which of the two you want to trade, start by looking at your leverage and your trading capital.
Then, ensure that you fully understand the markets in question as well as determining your risk tolerance and your goals for making profits. CFD’s are diverse and vary from one security to another, therefore pay attention to the individual securities and proceed accordingly.
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Alvexo is owned and operated by VPR Safe Financial Group Limited, supervised and regulated by:
The Cyprus Securities and Exchange Commission (CySEC) with license number 236/14 and company registration number HE 322134 , located at 1, Agias Fylaxeos Street, 3025 Limassol, Cyprus.
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Forex and CFDs are leveraged products and you may lose all your investment capital. Trading leveraged products carries a high level of risk and may not be suitable for all investors. You should consider your investment objectives, level of experience, financial resources, risk appetite carefully and seek independent advice if necessary. 80.7% of retail investor accounts lose money when trading CFDs with this provider. Please read the risk warning policy before entering any transaction with VPR Safe Financial Group Limited a Cyprus Investment Firm. For more information regarding the companies risk disclosure please follow the link
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