Contracts for difference (or CFDs) are a type of derivative product that allows buyers and sellers to exchange the difference between the present price of an underlying asset and the price when the contract is closed. CFD trading can be used with a wide range of underlying assets, including equities, currencies, commodities and indices.
CFDs were first developed on the London Stock Exchange in the 1980s by market maker Smith New Court. The products emerged in response to interest from investors who wanted to be able to sell stocks short without having to first take the costly and complicated step of borrowing them.
The products attracted the interest of institutional investors and hedge funds, and several equity market makers began to offer them as over-the-counter products. CFDs later gained interest from individual investors and in the late 1990s, they were launched as a retail product by Gerard and National Intercommodities through its electronic trading system.
With the growing popularity of the product, several other UK and European institutions began to offer CFDs. Since that time, their use has spread to several other regions, including Australia, the eurozone, Russia, Japan, Canada, South Africa, Switzerland, Canada and New Zealand. CFDs in the U.S. are considered to be security-based swaps and are regulated under legislation governing swap trading.
How A CFD Works
The contract for difference, as the name implies, is a contract between a buyer and a broker or other selling institution to exchange the difference between the purchase price on the contract and the price at which it is sold. Buying or selling a CFD serves as a proxy for buying or selling an underlying asset, without the need to actually exchange the asset.
If the price of an asset rises and the contract is closed, the seller of the CFD, or counterparty, must pay the difference between the current price of the shares and the price when the contract was made. However, if the price falls, then the buyer pays the price difference to the seller.
Thus, if the price of the underlying instrument rises, the buyer profits; and if it falls, the seller profits. As a contract, the CFD itself is not a tradable instrument. Equity CFDs have no fixed contract size or expiration date. Size and expiration for other types of instruments are based on the contract for the underlying asset.
Go Long Or Short
CFDs can involve long or short trades. In a long CFD trade, a trader enters a contract to buy with the hope that the price of the underlying asset will rise. In a short CFD trade, a trader enters a contract to sell with the hope that the price of the underlying asset will fall.
In a long CFD trade example, a buyer could use a margin account to purchase 10,000 CFDs on an underlying asset trading at US$4.20, to obtain a position worth US$42,000. If the asset price rises to US$4.50, the contract can be closed at a position worth US$45,000, offering a gross profit of US$3,000. However, if the price falls to US$4, the trade will produce a loss of US$2,000.
Similarly, in a short trade, a seller could offer 10,000 CFDs on an underlying instrument trading at US$6.20. If the price fell to US$6 then the trade would produce a profit of US$2,000. If the price rose to US$6.50, the seller would see a loss of US$3,000.
With either of these types of trades, the trader entering the contract would also be responsible for any associated trading costs, including commissions, taxes and financing costs.
Advantages Of CFDs
CFDs are considered to be attractive because they can be obtained with low margins, meaning that the potential for leveraging gains can be large.
CFDs can be granted tax advantages in some national trading jurisdictions. In the U.K., for example, CFDs are exempt from the "stamp duty" charged on traditional equities trading. Any losses incurred with CFDs can be used to offset payment of capital gains taxes on profits.
Risks of CFD Investing
Because CFDs can be obtained with low margins, they can expose traders to the potential not only for large gains, but also to large losses. Thus, traders should evaluate their tolerance for possible losses before engaging in CFD trading.
In addition to possible losses, CFD traders will need to consider other associated costs, including commissions to brokers, account management fees, taxes and overnight financing costs. For each day that a position is open, the contract holder may need to pay an interest charge on the notional value of the contract.
Liquidity And Execution Risks
Along with costs and loss risks, there may be other risks associated with CFDs. These include liquidity and execution risks. Liquidity risk is the risk that an asset may not be available to trade at the price or quantity desired. Similarly, execution risk arises when there is a lag between the time when an order is placed and the time when it is executed.
CFDs can allow investors to speculate on rises and declines in asset prices without holding the assets in question, and leveraging gains on a small amount of initial investment through use of margin accounts. CFD traders, however, may be exposed to market, liquidity and execution risks in addition to costs that can cause losses or diminish potential profits.
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