What are CFDs?
A Contract For Difference (CFD) is a derivative product which allows traders to speculate on the movement in the price of an asset. Put simply, a CFD is a contract between two parties, a buyer and a seller. Both parties agree to exchange the difference in the value of a financial asset between the time of opening and closing of the contract.
That asset could be:
- a currency pair (such as EUR/USD, known as a forex CFD)
- a commodity (such as Gold in commodity CFDs)
- an index (such as FTSE 100 index CFDs)
- shares in a company (such as Amazon equity CFDs)
They are synthetic products, so neither party owns the underlying asset. However, it does replicate price movements in the underlying assets. So, the buyer of the CFDs does not own the company shares or the commodities and CFDs are not traded on an exchange or a market. CFD trading is purely an agreement between the buyer and the seller.
A CFD is a contract between a buyer and a seller to pay the difference in the value of the contract between the opening price and the closing price.
- If the price moves higher, the seller pays the buyer the difference.
- If the price moves lower the buyer pays the seller the difference.
CFDs are a leveraged product
Where CFDs gain their popularity is that they are leveraged products. This means for a small initial deposit traders can gain exposure to a much larger position.
By trading on margin, the trader often only has to put down a small percentage of the cost of the position. Although, this does mean that any potential profits or losses will also be magnified.
Opening an equities CFD position with a margin of 10% would mean that the initial deposit only needs to be 10% of the full position. Through this, the position is said to be leveraged by 10 times.
A CFD trade in practice
In practice, CFDs are contracts between a trader and a financial institution such as a broker.
- If the trader believes the price will increase, they will buy the CFDs and the broker will be the seller.
- If the trader believes the price will decrease, they will sell the CFDs, with the broker taking the other side of the trade as the buyer.
Step 1 – Opening the trade
If a trader wants to buy Amazon shares, they can either buy the shares or buy Amazon CFDs.
If the share price is $90, buying 100 shares would cost $9000. However, trading Amazon CFDs on a 10% margin would only cost an initial deposit of $900 ($9000 x 10%) to be exposed to the same $9000 position.
| Price | Number | Cost / Deposit | |
| Buying Shares | $90 | 100 shares | $90 x 100 = $9000 |
| Buying CFDs | $90 | 100 CFDs (on 10% margin) | $90 x (100 x 10%) = $900 |
Step 2 – Closing the trade
If the Amazon share price (CFD price) moves up to $95 and the trader closes the position (i.e. sells the contract), the trade is profitable:
$5 (the difference in value from open to close) X 100 CFD contracts = $500
For an initial deposit of $900, the trader has made $500 in profit.
However, what if the Amazon share price falls to $84 before the trader chooses to close the position?
-$6 (the difference in value from open to close) X 100 CFD contracts = -$600
There is a loss of -$600 that has been incurred.
Don’t forget, when trading CFDs, both the profits and the losses are magnified. Furthermore, with CFDs, it is possible to lose more than the value of the initial deposit.
The benefits and risks of CFDs
Here are a few pros and cons that should be considered before trading CFDs.
Pros:
- Margin trading enables increased exposure at lower costs – Gain exposure to larger positions with a smaller initial deposit.
- Trading on margin increases profit potential – Margin trading can significantly increase profit potential.
- Trading long or short – CFDs allow traders to go long (buy) or short (sell), giving them the potential to profit from all market conditions.
Cons:
- Increased risk of losses – Margin trading is a higher-risk trading strategy which can result in significant losses.
- No ownership rights – There are no ownership rights with CFDs.
