In financial terminology, a contract for difference (CFD) is the name given to an agreement — typically made between a broker and an investor — establishing that one party will pay the other the difference in the value of a certain security between the start and end of the contract.
With CFD trading, you’re essentially betting on which way the market for a particular financial instrument will move; if your prediction is correct, you make money — if not, you lose.
What sets CFD trading apart from traditional currency exchanges is that you don’t actually own the assets you’re speculating on at any given time, and so there’s no delivery or transfer of physical goods between you and the broker; you’re simply betting between yourselves on the security’s fortunes over a given time period.
Trading Derivatives with CFDs
A common form of ‘derivative’ trading (the name given to financial investments tied to an underlying asset), investors can trade CFDs on a wide range of markets, including currencies, stocks, bonds, indices and commodities.
It’s not unusual for a single broker to offer CFDs on a variety of products in all major global markets, making them an efficient way to trade with a diverse portfolio of financial vehicles around the clock.
Historically traded amongst financial institutions such as banks, investment companies and insurance dealers, CFDs have also become increasingly popular with retail clients during the last decade, as they enable you to participate in the trading market without owning any of the securities yourself.
Despite this growing prominence, CFDs are not permitted in certain countries, most notably the US. American financial regulations consider CFDs a form of gambling (and therefore illegal for private citizens), while strict rules pertaining to ‘over-the-counter’ (OTC) products forbid the trading of CFDs more generally unless it’s carried out on a registered exchange — none of which currently exist!
How Do CFDs Work?
When trading with CFDs, speculators will either bet on the price of a given security moving upwards (‘going long’) or downwards (‘going short’). Those expecting an upwards movement will purchase a contract for that instrument, while those betting on a downward movement will open a sell position in the hopes of ultimately profiting from a price decrease.
Unlike futures or option contracts, CFDs have no expiry date or time decay: they’re essentially renewed at the close of each trading day and speculators can keep their position open for however long they like, as long as there are sufficient funds in the trader’s account to cover the expenditure.
Once the position is eventually closed, the trader’s account is then either debited or credited in accordance with the asset’s performance with respect to their original prediction.
What Makes CFD Trading Unique?
Due in part to their purely speculative nature — and despite efforts by the European Securities and Markets Authority (ESMA) to ensure retail investors are protected — the markets for CFDs tend to be less regulated than those arrangements that entail assets physically changing hands, and they aren’t as restricted by minimal capital requirements or any caps on the frequency of trades.
CFD agreements also typically involve very few fees (you don’t have to pay stamp duty on your profits, for example) and many brokers won’t charge you at all to enter or exit a trade. Instead, they make their money by having you cover the spread cost; you’re effectively required to pay the ask price to buy and must take their bid price in order to sell.
However, this greater degree of freedom isn’t without its own set of dangers. For instance, it can be trickier to ensure any particular broker is credible, as the more relaxed rules mean you only really have their reputation and financial position to go on — so it’s doubly important to do your research before you commit to anything!
Additionally, CFDs are notable in that you’re able to speculate on price movements in either direction, and you’ll make money as long as your prediction proves correct. This means you can profit even if the value of the asset you’re betting on decreases — similarly, though, it’s quite possible to lose money from a price increase if your original hypothesis is wrong.
