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Contract for Difference (CFD)

Contract for difference (CFD)A contract for difference is a form of derivatives trading where the value is derived from the performance of an underlying entity, such as an asset, index, or interest rate. As a result, you can speculate on the rising or falling prices of fast-moving global financial markets in the form of commodities, currencies, foreign exchange, indices, shares, and treasuries.

What Is A Contract for Difference (CFD)?

A CFD is a cost-efficient way to trade on the price movement of thousands of global financial markets. Under a CFD, you do not buy or sell the underlying entity. Since you do not own the underlying entity, you will not have to pay the stamp duty.

If you see that the product goes up in value, you can sell a number of units or go long. And vice versa, if the value of the product drops down, you can sell a number of units or go short.

Each product has a sell price and a buy price. The difference between the buy and sells price is called a spread. During CFD trading, you must pay the spread. You can enter a buy trade by using the buy price and exit by using the sell price.

The more points the market moves in your chosen direction, the more profit you make. Your profit equals the difference multiplied by the number of units.

Example

Let’s consider an example. The quoted sell price of a product is $560 and the buy price is $561, so the spread is 1. You buy 5 units of a product at $561, paying $2,805 in total. Then the sell price goes up by 5 points and the buy price goes up by 6 points, resulting in $565 and $567, accordingly. So you sell those same 5 units at $565, making $2,825 in total. As a result, your profit will be $2,825 - $2,805 = $25.

If a market moves in the opposite direction, you will make a loss. For example, if you sell the 5 units at $ 558, you will make $2,790. As a result, you will lose $15 ($2,790 - $2,805).

Advantages

CFD trading has the following benefits for traders:

  • Lower margin requirements starting at 2%, which means less capital outlay and greater potential returns.
  • There are no minimum amounts of capital for the CFD market.
  • CFDs mirror corporate actions, so a CFD owner receives cash dividends and takes part in stock splits, increasing the trader’s ROI.
  • Easy access to any market that is open from the broker’s platform. Most CFD brokers offer products in all major markets across the world.
  • No short selling values. The trader does not own the underlying asset, so there is no borrowing or shorting cost. Moreover, few or no fees are charged for CFD trading. Brokers make money from the trader paying the spread.

Disadvantages

Despite a wide range of advantages, CFD trading also has some drawbacks, such as:

  • It is hard to trust CFD brokers because the CFD industry is not highly regulated. As a result, the broker’s credibility is based only on their reputation.
  • Profiting from small moves is prevented because of paying the spread on entries and exits.
  • A CFD is not suitable for long term positions or buy-and-hold trading because the trader has to pay the holding costs at the end of each trading day.

Summary

A contract for difference is an easy way to trade on global financial markets. The most remarkable feature is that the trader does not own the underlying entity. The difference between the quoted sell and buy price of the products is called a spread, which the trader must pay when trading. The advantages are lower margin requirements, no minimum capital, easy access to global markets, and no short selling values. The drawbacks are the lack of regulation within the industry, no profits from small moves, and high holding costs.