A Contract for Difference (CFD) is a speculative financial instrument that can be traded online with a CFD broker.
It is important to understand that trading CFDs online carries a certain degree of risk, namely, the risk of losing money. This makes them less risky than an activity such as skydiving or deep-sea diving, where the potential risk is the loss of life. So long as only money that can affordably be lost is used to trade CFDs, the risk is not life threatening and is mainly limited to the psychological feelings of the trader.
Here is how CFD trading works.
Mechanics of CFD Trading
A trader can be either a buyer or seller of a CFD instrument. Initiating a trade as either creates a contract between the buyer and the seller. The contract states that the seller will pay the difference between the price of the contract at the time of purchase and the value of the contract when the transaction is terminated. If the price difference increases, the buyer makes a profit. If the price difference decreases, the buyer must pay the difference to the seller, accepting a loss on the transaction. For the seller of a CFD, the profit/loss scenario is the exact opposite.
Costs Involved With Trading CFDs
CFD providers charge a daily financing fee for trading CFDs. The charge varies according to the type of CFD broker used. The most common CFD broker is the market maker. A market maker determines the price of the CFD. This price can be different from what the selected financial instrument in the trade might otherwise be, but reputable market makers often provide a guarantee that their price will match the market price of the underlying instrument.
The other type of CFD provider is called Direct Market Access (DMA). This provider absolutely guarantees that the CFD price quoted will match the underlying price. Professional traders prefer the DMA CFD provider because there is no potential conflict of interest between the trader and the broker.
Other trading costs that may be encountered are a bid-offer spread, commissions, fees for holding CFD positions overnight and account management fees. Commissions are added to losing trades and subtracted from winning trades, something that should never be forgotten.
Traders should research CFD providers carefully to find the best possible combination of provider services and costs in order to determine which provider supplies the most cost-efficient trading route.
CFDs Compared to Other Financial Instruments
Like most speculative trading, CFD trading is done on margin, meaning that a trader need only have a relatively small percentage of the value of an instrument in order to enter into a trade for that instrument. CFDs also involve leverage, which is both a benefit and risk of CFD trading. Leverage is the effect of using a small amount of money to take a much larger market position. A small change in the price of an instrument provides a large profit if the trader was correct in predicting the direction of the change, but also a large loss if incorrect.
• Unlike Futures and Options, there is no expiration date on a CFD contract, so the value is not affected by time decay.
• All CFD trading is done over-the-counter; there are no trading floors with buyers and sellers in trading pits.
• It is easy to create new CFDs. If there is adequate demand from traders, brokers will make new CFDs available.
CFDs represent an opportunity for short and long-term trades and should be considered as a potential component of a diversified investment portfolio. Traders of stocks, bonds, futures and options will grasp the CFD concept readily. New traders are well advised to research CFDs thoroughly and if possible, practice trading with a simulated account in order to gain firsthand experience with the reality of CFD trading.