Contract for Difference (CFD)

CFD which stands for Contract for Difference is a financial instrument which lets the investors’ trade by speculating the price movements on any kind of financial market be it equity or commodities or currencies and even in the bond market. You can trade CFD’s when the prices are falling or rising as the profit is made from the difference of the prices, so the direction of price movement doesn’t affect it. Since you do not own the underlying asset, there is no question of paying any UK stamp duty for the profits you make.

What is ‘long’ or ‘short’ CFD?

You can either ‘long’ or ‘short’ your CFD depending on your analysis of the price movement. If you are ‘going long’ it means you are buying CFD and expect a rise in the prices of the underlying asset and ‘going short’ means you are expecting a fall in the underlying asset’s value and thus selling the CFD. The main motive is to make a profit out of the difference in prices that is the opening value and the closing value of the contract/CFD.

Suppose, you bought (‘going long’) a CFD on Company X’s shares and the prices of the shares actually rise after a certain point in time and you close the contract. The seller of the CFD will pay you the difference amount of the price of the contract on the date of closure and the price at which it was bought. But if the price falls, then you need to pay the seller the difference amount.

How a CFD works?

As mentioned in the above example, if the price moves in the favour of the buyer then the difference amount will be paid by the seller to the buyer and vice versa. At the time of opening a CFD position, you can select the different CFDs amount which you would like to trade and the if the market moves in favour of yours’, then your profit will also keep on increasing according to the price movement.

‘Going long’ on CFDs

If you expect the price of your selected market will rise, you click to buy the CFD and with every increase in the points, your profit increases but if the price starts falling against your expectation, you tend to lose money with every decrease in the points.
Suppose, you expect oil prices to rise and thus you buy 10 CFDs at £5325 and the market moves 30 points up when you close the contract. So, the current price after the increase is £5355, thus you make a profit of 30 points for one CFD and in total £150 for 5 CFDs. But if the market price falls by 30 points to £5295 then you lose £150.

Shorting CFD

You expect a fall in the market price of an underlying asset of a company and thus ‘short’ or sell CFDs and if the prices fall in real, you make a profit out of the difference of prices.
Let’s say, you ‘short’ or sold 5 US 500 CFDs at £2340, expecting a fall in its price due to the upcoming earning session, which is going to disappoint the investors. The price actually decreases by 65 points and the price becomes £2275 and you close the contract making a profit of £325 (65 times of 5 CFDs).

Hedging

A CFD lets you make a short sale, thereby helping you make a considerable profit from even the falling market price. This is why CFDs can be used to offer insurance against the losses that they’ve made in physical portfolios.

Let’s say if you have £5,000 in Barclay’s shares and you’re worried that they need a sell-off soon. You can keep your share portfolio safe by making a short sale of £5,000 in Barclay’s CFDs. If the prices of Barclay’s shares fall in the underlying trading market by 5%, the loss in your share portfolio will be made up for by the gain in your CFD short sale. This way, you can keep your portfolio protected without facing the inconvenience and expense of stock liquidation.

Types of CFD Brokers

More and more CFD brokers are going online. Much like Forex brokers they give you direct access through a platform to trade CFD’s on your own behalf.

CFD agents provide the investors with a chance to engage with the market directly. They offer CFDs that are linked to underlying equity positions. If you open a CFD position, your agent will reflect the same position on the asset class that matches the possible liability of a broker. This protects against the risks in the CFD position and creates the right situation for the broker when the upside exposure gets covered by a parallel position.

Market Makers aren’t like CFD agents in the sense that they don’t take any corresponding position when it comes to the underlying asset market. But instead, they take the risk with each transaction.

The spreads that the market makers offer provide a portion of the profit to the broker. CFD agents, on the other hand, get their share through a commission. Market makers are the ones that decide the spread and they mirror the current market.

Market makers take steps to prevent risks on their portfolio, but they don’t act like CFD agents and take corresponding positions. This allows them to cut direct costs and do more efficient trading.

The difference

There are subtle differences between the two types. But the main differences are in their prices and levels of transparency. With CFD agents, you get a live and direct portal that lets you access the markets. You can see the spreads accurately on their platforms and assess your current asset prices. With market makers, you can get the advantage of influencing the market.

Depending on your trading options and preferences, you can choose either of the two.

Contract for Difference (CFD)

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The Advantages and Disadvantages of CFD

Higher leverage: CFD offers higher leverage rates that traditional trading options

Single platform for global access: There are some CFD brokers that offer products in the world’s major markets. This lets you have a 24-hour access.

No fees: CFD brokers offer many processes similar to traditional brokers, such as limits, stops, and contingent orders. The brokers earn when trader opts to pay for the spread. Most brokers don’t charge a fee or commission.

Optional day trading: There are some markets that need you to enter a minimum amount of capital for day trading. However, the CFD trading is not dependent on such restrictions and as an account holder, you can day trader if you wish.

Number of options: Brokers offer stock, commodity, index, currency, and treasury CFDs so if you want a variety of trading options, you can choose CFD.

While there are several advantages of CFD, there are also some disadvantages as well. Here are the disadvantages of CFD.

You need to pay the spread: CFD is an attractive option for those who don’t want to invest in the traditional markets. But there are several pitfalls as well. For example, paying the spread on entries/exits reduces the chances to make a profit from small moves. While spread costs might be good for making money on big moves, they can cost a loss when you win a trade on a small amount. It will result in a loss if the winning amount is small. While traditional trading involves trader fees and commissions, it’s possible to make money on small wins in the traditional market but not in CFD.

Weak regulations: Since the CFD industry is not highly regulated, the credibility of CFD brokers depends on their financial position instead of a government standing.

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