What are CFDs?

A Contract for Difference (CFD) is a relatively new way of trading in the financial markets. It was first introduced in the early 1990s in London by Smith New Court, a derivative brokerage company, to short sell the market while using the advantage of leverage. Because of the technology boom in the late 1990s, CFDs became available to private retail traders, and it quickly expanded across the globe. Today, CFDs are traded throughout the world, including in Europe, Australia, Russia, South Africa, Japan, Canada, Switzerland and New Zealand.

A CFD refers to a contract agreement between a CFD broker and the broker’s client or trader. It is an agreement to exchange the difference between the opening and closing price of a CFD product in a particular trade. The contract payout is the amount of the difference between the opening and closing prices of the trade, multiplied by the number of underlying assets specified in the contract.

CFD (contract for difference) is a contract agreement, made between the CFD broker and the trader, to exchange the difference between the opening and closing price of a CFD product of a particular trade.

CFDs are derivative products; their prices are derived from underlying assets such as currencies, shares, commodities, bonds, and indices. Hence, when you trade a CFD, you do not own and trade the actual underlining asset. Rather, you are making an agreement to trade the difference in price of the underlying asset between the time the trade was opened and when it will be closed.

When you trade CFDs, you do not actually own the underlining asset—you are setting forth an agreement to trade the difference in price between the time you open a trade until the time you close it.

Because CFDs are traded on margin, you only need to deposit a fraction of the underlying asset market value, instead of funding the entire cost of the asset. This means that you can trade a CFD with as little as 1 percent of the overall CFD price. This gives you the ability to trade larger amounts of CFDs. However, the margin also amplifies the potential loss of a trade, making it possible to lose more than you initially invested. This makes a CFD a high-risk product.

CFD positions that are left open overnight are charged with overnight interest adjustments. These adjustments represent the financing fees to maintain your positions open. Overnight long positions are charged with interest, and overnight short positions are paid with interest. In other words, you will receive interest on your overnight short positions and you are required to pay interest on your overnight long positions. Interest is calculated daily, and interest rates vary across different types of brokers.

CFDs are traded on margin, which gives traders the ability to open larger trades. However, this also makes it possible to lose more than they initially invested. This makes a CFD a high-risk product.

Although CFD trading is analogous to trading ordinary shares, a trader who holds a CFD position has no ownership of the actual underlying asset. Therefore, the trader will not receive any dividend payment from the company that issued the shares. Instead, the CFD provider would 1) pay the equivalent of the dividend to a trader who was holding a long position during a dividend payment period, or 2) deduct the equivalent from a trader who was holding a short position during a dividend payment period. These adjustments are done to compensate the effects of dividends on share prices. So as you can see, even though you don’t own the actual underlining asset, you are still entitled to benefits that come with owning the actual share, such as the equivalent of dividends

As a general rule, the economic outcome of corporate action on any underlying asset must be reflected in the CFD. These corporate actions include stock splits, dividends, etc. However, a CFD holder will never be eligible for non-economic actions, such as voting rights.

Even though you don’t own the actual underlining asset, you are still entitled to benefits that come with owning the actual share, such as the equivalent of dividends

How CFDs are priced

CFDs are always quoted and traded based on the value and base currency of the underlying asset. Thus, U.S. stocks are priced in U.S. dollars and U.K. equities are in British pounds. The same principle also applies to indices; FTSE100 is quoted in British pounds and S&P500 in U.S. dollars. Many commodity CFDs, such as gold and silver, are also quoted in U.S. dollars.

Profit and loss are realized in the base currency of the traded underlying asset. For example, if you buy or sell a U.S. index CFD, your profit or loss will be in U.S. dollars. Alternatively, your profit or loss in buying or selling a U.K. index CFD will be in pounds. Your profit or loss is automatically calculated in your trading account’s base currency.

CFD prices are derived from the real underlining market prices. This means that a CFD broker makes his own prices and can be different from the underlining market price.

CFDs are always quoted with a bid and offer price. The bid price is always lower than the offer price. The bid price is the price that you get when you sell a CFD asset, while the offer price is the price at which you buy a CFD asset. The difference between the bid and offer price is the spread. Let’s say that Vodafone, a U.K.-based company, is quoting £120 to £120.1. You would sell at £120 (the bid price), or you would buy at £120.1 (the offer price). The spread is £0.1p.

CFDs are always quoted with a bid (Sell) and offer price (Buy). The bid price is always lower than the offer price, and the difference between the two is known as the spread.

Trading Equity CFDs

A single equity CFD is equivalent to one share. If you buy and sell one equity CFD, you are buying and selling a single share. Let’s consider the example below:

Let’s assume that Vodafone is currently trading at £160 to £160.5

John Trader believes that Vodafone is going to increase in value and places a trade to buy 1000 CFD shares at £160.5. The total value of this contract would be £1605 ([160.5p x 1000]/100), but an initial 10-percent margin is only needed to make a purchase. This means that John Trader only needs to deposit £160.5. The commission charged on the transaction is £3.21 (£1605 x 0.20%).

After two days, John’s market analysis proves to be correct, and Vodafone is now trading at £165 to £165.5. He decides to close the trade by selling 1000 Vodafone CFDs at £165. The commission charged on his sell transaction is £3.3 (£1650 x 0.20%). Because the long position was held for two days, overnight financing charge of £5 will be charged to John’s account.

John’s total profit is calculated as follows:

               Opening price:                                  160.5p

               Closing price:                                    165.0p

               Difference:                                         4.5p

  Profit on Trade: 4.5p x 1000 = 4500p = £45

               Total commission:                          £6.51

               Overnight Financing Charge:         £5.0

               Total Profit: £45 - £6.51 - £5.0 = £33.49

To calculate the total profit of the trade, take into consideration the commission and financing charges. Not all CFD providers charge commissions on trades. Thus, it’s very critical that you understand how CFD providers differ when conducting the same business. 

Trading Index CFD

Indices are global stock exchanges such as NASDAQ, DJ 30, S&P 500, DAX 30, FTSE, etc. For indices and commodities, one CFD is the equivalent to one contract of the underlying asset. Trading an index CFD is very similar to trading an equity CFD. Let’s consider the simple example below:

Let’s assume that FTSE is currently trading at £5802 to £5803.

John Trader bought one CFD at 5803, as he expected that the index would increase in value. However, things didn’t go as anticipated, and the index went down to £5783 - £5784. On the same day, he decided to close the trade by selling one CFD at the bid price of £5783.

John’s total profit is calculated as follows:

               Closing price:                                   5783p

      Opening price:                                  5803p

               Difference:                                        -20p

    Profit on Trade: -20p x 1000  = -£20 (Loss excluding commission charges)

A single equity CFD is equivalent to one share.

Trading Commodity CFDs

Commodities are products and precious metals, such as gold, oil, silver, sugar, corn, wheat, soybean, etc. Trading a commodity CFD is very similar to trading equity and index CFDs. Commodities are traded in USD per unit that varies according to the type of CFD. Commodity units are set to a standardized quantity called lots. For example:

o Oil is traded in U.S. dollars per barrels (USD/bbl)

o Wheat is traded in U.S. dollars per bushels (USD/bu)

o Coffee is traded in U.S. dollars per pounds (USD/lb)

One Commodity CFD is equivalent to one unit and varies depending on the commodity that is being traded.

CFD Broker Role

The CFD provider acts as a liquidity provider for all of the broker’s clients. The provider quotes its own price for the underlying asset based on the asset’s cash market value. However, for some CFD providers, there are discrepancies between the CFD price and real asset’s cash market value. In some countries, authorities have come up with regulations to ensure that the CFD contracts reflect the prevailing market value of the assets in question. In the U.K., the Financial Conduct Authority (FCA) has passed disclosure regulations to bring transparency to the markets and CFD holdings. Thus, a CFD provider must adhere to the regulatory guidelines imposed by the various exchanges and regulatory authorities.

A few years ago, concerns about the pricing of CFDs led to the introduction of a special kind of CFD called DMA, or Direct Market Access CFDs. These usually require that the provider show certified proof of a matching transaction involving their transactions. This means that for every CFD transaction, the provider is compelled to trade simultaneously in the underlying asset. This rule ensures that there are minimal inconsistencies between the CFD price and the real value of the underlying asset. This helps to protect investors from exploitation by rogue providers who like to set different prices in order to widen the margins in their favor. Nevertheless, since the CFD provider also acts as the stockbroker for his clients, he still has the liberty to determine the specific terms of the contract. As an investor, you too have the liberty of choosing the best terms from different providers. Find out which provider suits you with Tradingfo´s broker reviews.

CFD brokers act as liquidity providers—always offering a buy and a sell price. You will find that these types of brokers also offer Direct Market Access (DMA), which give more transparency in terms of pricing.

Bottom Line

CFDs are relatively new to the world of finance, giving investors and traders easy access to the world of trading. CFDs offer high leverage and a variety of financial products to choose from. Brokers who offer these types of derivative products are normally market makers who provide their own market prices, which in turn can vary from the underlining price. CFDs are normally used by more experienced investors, as the extensive leverage makes this a high-risk product. Some investors and traders utilize CFDs as a hedge to their other trading positions, or they use CFDs as their main source for trading.


Summary:

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CFD (contract for difference) is a contract agreement, made between the CFD broker and the trader, to exchange the difference between the opening and closing price of a CFD product of a particular trade.

 

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When you trade CFDs, you do not actually own the underlining asset—you are setting forth an agreement to trade the difference in price between the time you open a trade until the time you close it.

 

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CFDs are traded on margin, which gives traders the ability to open larger trades. However, this also makes it possible to lose more than they initially invested. This makes a CFD a high-risk product. 

 

P
P

Even though you don’t own the actual underlining asset, you are still entitled to benefits that come with owning the actual share, such as the equivalent of dividends.

 

P

CFD prices are derived from the real underlining market prices. This means that a CFD broker makes his own prices and can be different from the underlining market price.

 

P

CFDs are always quoted with a bid (Sell) and offer price (Buy). The bid price is always lower than the offer price, and the difference between the two is known as the spread.

 

P

A single equity CFD is equivalent to one share.

 

P

One Commodity CFD is equivalent to one unit and varies depending on the commodity that is being traded.

 

P

CFD brokers act as liquidity providers—always offering a buy and a sell price. You will find that these types of brokers also offer Direct Market Access (DMA), which give more transparency in terms of pricing. 

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