Contract for difference

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A contract for difference (or CFD) is a contract between two parties, buyer and seller, stipulating that the seller will pay to the buyer the difference between the current value of an asset and its value at contract time. (If the difference is negative, then the buyer pays instead to the seller). Such a contract is an equity derivative that allows investors to speculate on share price movements, without the need for ownership of the underlying shares.

Contracts for differences allow investors to take long or short positions, and unlike futures contracts have no fixed expiry date or contract size. Trades are conducted on a leveraged basis with margins typically starting at 10% of the notional value for CFDs on leading equities.

CFDs are currently available in listed and/or over-the-counter markets in the United Kingdom, Germany, Switzerland, Italy, Singapore, South Africa, Australia, and most recently New Zealand. Some other securities markets, such as Hong Kong, have plans to issue CFDs in the near future.

Contents 1 Charges 2 Additional Benefits 3 CFD Dealers reputation 4 Risk

[edit] Charges

The contracts are subject to a daily financing charge, usually applied at a previously agreed rate above or below LIBOR or some other interest rate benchmark. The parties to a CFD pay to finance long positions and (may) receive funding on short positions in lieu of deferring sale proceeds. The contracts are settled for the cash differential between the price of the opening and closing trades.

Traditionally, CFDs are subject to a commission charge that is a percentage of the size of the position, usually between 0.2%-0.25%, that is calculated on the size of the position. This charge is made on each trade, including when the position is closed. Alternatively, an investor can opt to trade with a market maker, foregoing commissions at the expense of a (usually) larger bid/offer spread on the instrument.

Investors in CFDs are required to maintain a certain amount of margin as defined by the brokerage or market maker (ranging from 1% to 30% usually). One advantage to investors of not having to put up as collateral the full notional value of the CFD is that a given quantity of capital can control a larger position, amplifying the potential for profit or loss. On the other hand, a heavily leveraged position in a volatile CFD can expose the buyer to one or more margin calls in a downturn.

As with any leveraged product, maximum exposure is not limited to the initial investment; it is possible to lose more than one put in. These risks are typically mitigated through use of stop orders and other risk reduction strategies (for the most risk averse, guaranteed stop loss orders are available at the cost of an additional one-point premium on the position and/or an inflated commission on the trade).

[edit] Additional Benefits

In addition to avoiding stamp duty, increased flexibility and leverage are other advantages of CFD's over more conventional forms of margin trading. All forms of margin trading involve financing charges (with the exception of the Foreign Exchange market), although in the case of CFD's and futures contracts these are embedded in the price of the instrument. Futures, whilst a bit less flexible than CFD's, may offer more competitive pricing and they offer the advantage of not passing orders through a market maker(unlike the CFD),which is important if you think your Market Maker could be not 100% reliable.

[edit] CFD Dealers reputation

Although some professional traders use CFD,it is a widely known fact that most CFD trades are unhedged when it comes to individual investors(the fact that we don't "own" the stock make it easier),so it means that a lot of retail CFD dealers out there are bucketshops,anyway even at the best broker,most people will stastically blow up their account in a few months given the tremendous leverage offered and the wreckless marketing incitating individual traders to trade a lot(the broker earns the fees + the deposit).

However, a number of CFD dealing services offer direct market access and ones such as these of course, whilst acting as counterparty, are hedging your every trade in the market for you. Simply put; understanding of the potential risk involved in trading CFDs is always crucial.

• Contracts for differences are not permitted in the United States, due to restrictions by the U.S. Securities and Exchange Commission on OTC financial instruments.

[edit] Risk

CFDs allow a trader to go short or long on any position with a variable margin (set by the brokerage) that allows them to trade on margins of up to 5% (and sometimes 1%); lack of appreciation for the sort of exposure that can be experienced from taking full advantage of such financing is hence a crucial reason that many CFD traders lose; whereas a solid money management strategy can allow a trader to take full advantage of CFDs to their benefit; the CFD broker or principal will always be required to mirror the underlying market valuation and as a result, when risk management is applied, CFDs can be a solid trading tool.

Therefore, anyone approaching CFDs should always look to analyze what they could lose, as opposed to simply focussing on what they could gain.