A Contract for Difference (CFD) is a type of financial derivative where two parties agree to exchange the difference between an underlying asset’s opening and closing value. A CFD is legally binding, and the contract creates, defines and governs the rights and obligations of the two parties.
The two parties are normally referred to as “buyer” and “seller”, respectively, even though the underlying asset is not being bought and sold.
- Just like other derivatives, a CFD can be used to get exposure to the price movements of an asset without owning that asset.
- CFDs are always cash-settled.
- You can use CFDs for speculation regardless of which direction you think a price will go (up or down) – just select the appropriate CFD. CFDs can therefore be used to avoid risky and complex short-selling in falling markets.
- Brokers that offer CFDs typically also offer ample leverage.
- CFDs have become especially popular for very short-term speculation.
- CFDs are not traded on major exchanges such as NYSE or Nasdaq. Instead, they are traded over-the-counter (OTC).
This financial derivative was developed in Great Britain in 1974 as a way to leverage gold. The original Contracts for Difference were a type of equity swap traded on margin. The creation of the CFD is widely credited to Brian Keelan and Jon Wood, who both worked for UBS Warburg. Today known as the UBS Group AG, this the largest Swiss banking institution and the largest private bank in the world.
- You believe that the share price of the Exchange-traded fund Invesco QQQ will go up.
- Your broker requires that you put up 5% of the trade and is willing to lend you the rest (leverage).
- You buy a CFD where the underlying asset is 100 shares in the QQQ. With the price at $250 per share, the total position is $25,000. You only have to put up $1,250 of that right now as you can borrow the rest from your broker.
- 2 months later, the QQQ price has moved up to $300 per share. You decide to exit your position. The difference between $300 and $250 is $50, so you make a profit of $50 per share. $50 x 100 shares = $5,000.
- The CFD is cash settled. The initial position of $25,000 and the closing position of $30,000 are netted out. The gain of $5,000 is put into your trading account by the broker.
Why are CFDs so popular?
Here are a few reasons why CFDs have become so popular:
- They make it easy to gain exposure to a price movement without actually buying, owning and selling the asset.
- They make it easy to speculate on both upwards and downwards price movements.
- They are always cash-settled.
- Brokers that offer CFDs normally also offer generous leverage.
Examples of risks
You can always lose the money you risk on CFDs. Do no risk money you can not afford to lose. This is especially important when using leverage. Leverage amplify both gains and losses.
Just as for any other investment strategy, it is strongly recommended to diversify when using CFDs, in order to achieve appropriate risk-management.
If the underlying asset experiences extreme volatility, the bid and ask prices spread can be very wide. If you are paying a large spread on entries and exits, it will be difficult or even impossible to make any relevant profits from small movements, as they spreads will “eat your gains”.
CFDs are traded over-the-counter, which means less regulation and weaker safety nets for traders.