A Contract for Difference (CFD) is the agreement between two parties to exchange the difference in contract value for a pre-determined financial instrument between the opening price and closing price of this contract.
Essentially, CFD is an attempt to transfer the principles of the foreign currency market, Forex, into all stock and over-the counter markets. The client shifts all liabilities for such access provision to a certain broker’s shoulders.
The true advantage of such contracts is the opportunity to simultaneously access different markets, mainly stock exchanges, while only using one trading account. In this context “One” is the keyword, since the depletion of funds does not always have a positive effect on the account provision. This may mean that sooner or later, while working with different accounts in various financial market segments, the so-called “margin deficit” may arise because there are not enough resources in one account to maintain an open position at its initial volume. It is quite possible that the account from another broker will be able to cover the deficit. However, new costs may arise, which are related to transferring the money.
Similar to currency instruments, CFDs are margin products which allow the investor to receive higher yields by using the offered leverage. This means that the investor can buy a CFD without having the full amount to buy the respective shares. For example, in order to buy GE shares for the amount of $10,000, the client will need a deposit of only $1,000. The profit of $1,000 would give 10% yield if the corresponding shares were traded, but it gives 100% yield while trading on CFD. However, it should be noted that losses are multiplied likewise. Nevertheless, the advantages of CFDs are quite impressive, and today this trading instrument has reached great popularity.
Main advantages of CFDs are as follows:
Maximum account diversification
Minimum deposit requirements, minimum sum of transaction – 0.1 lot = 10 shares
Low collateral requirements, almost in all positions the required collateral is only 5-10% of contract value allowing for portfolio investments without tying up all funds of the investor
Minimal or zero commission
No need to wait for order confirmation at stock exchange
Laying all your concerns related to quotations with the brokerage firm which actually acts as a market-maker for client
Obtaining market spreads without any extensions, allowing trading at the same prices as those used by stock exchange participants
Guaranteed execution of stop orders at any movement of the market, which is difficult to achieve even working directly on the stock exchange – strong market movements lead to execution of orders at the knowingly worse rate for the investor
Of course listing the advantages, we cannot avoid mentioning certain disadvantages of these instruments. One of these disadvantages is the initially speculative nature of trading. Using CFD, you cannot demand actual delivery. Nevertheless, this shortcoming does not seem to present a serious obstacle for bidders as, according to statistics, it is speculative operations that most market players are interested in.
Undoubtedly, the stock market is attractive in and of itself, and mainly for conservative reasons. You become the owner of the company’s assets – the investor – your name is entered into the registry of stockholders. If you hold onto the assets for and extended period of time, you will be paid dividends according to the current laws. This is not the case with CFDs. The distinctive feature of CFD trading is that you do not trade in shares. Literally, no operations with actual assets take place. This means you cannot become a stockholder of the company whose CFD you have purchased. The trader makes a contract only for the movement of the actual rate, the evidence which can be seen in all alternative data sources. In other words, this is not playing Russian roulette. Betting is made for real change of the exchange rate on the basis of careful analysis of general economic tendencies. This is an active position. A professional or just an active participant of the market, with a keen interest in economic environment and sound judgment (rather than reliance on outside opinion) has more chances to earn money as well as guard it from inflation and any changes in the market. Here, like in other market segments, a competent trader can detect the oncoming movement at its earliest stage of conception, and use it to his advantage.
Another advantage is the stream-like nature of quotation. Buy and sell rates change every second. To execute a transaction you need not request a broker, everything is carried out in the automated mode. This means that quotation is done by the computer and the time of execution is 0.01 second. When you click the button, you know for sure the price of your transaction.
Using CFDs you can also perform financial transactions on commodities and securities markets in the USA, Japan, and the European Union, including countries with the largest economic systems like Germany, France, Italy and Holland. There are opportunities to trade on various markets as far as Australia and New Zealand; futures are available on the major world indexes: Dow Jones, NASDAQ, NIKKEI, S&P 500, and CAC 40.
One more application of these contracts is hedging. If you physically hold stock, which you do not want to sell even when anticipating the fall of the rate, you may simply take a short (sell) position on contract for difference for this share (or the whole stock). Then the losses you incur on the basic asset will be compensated by the profit from the corresponding operation.
