The Basics of Contract for Difference (CFD)

Since markets and exchanges for stocks, indices, commodities, and currency are commonly heard when economic news is in the spotlight, beginners often ask “what is a CFD?”.

Contract for Difference or CFD is a contract that allows two parties to enter into an agreement to trade financial instruments based on the price difference of the entry prices and closing prices. If the closing trade price is higher than the opening price, then the seller will pay the buyer for the difference. That will become the buyer’s profit. On the other hand, if the closing trade price is lower than the opening price, then, it is the seller that will benefit from the difference.

By just placing a small margin deposit to hold a trading position, a contract for difference provides the traders with an opportunity to leverage trading. Substantial flexibility and opportunity are also provided to the traders. For example, there are no restrictions on the timing of the entry and exit and on the time over the period of exchange. Also, there is no restriction on entering trade buying or short selling.

How CFD works?

CFD trading does not need to own any tangible asset unlike stocks, bonds, and other financial instruments. CFD trade on margin with units that are joined to a given security’s price which are based on the market value of that certain security. Without purchasing the security, CFD is about speculating on the changes in its price. In other words, it is a contract that is made to profit on the price difference of security between the opening and closing of the contract. Actually, this is the main highlight of what is a CFD all about and its difference to traditional financial instruments.

CFD Common Terms

·         Going Long vs Going Short

Going Long – the trader is anticipating a price increase. Therefore, the trader opens a CFD position. The is trading on the long side.

Going Short – the trader is anticipating a price decrease. Therefore, the trader opens a sell position. Trading from the selling position is called going short.

·         Margin and Leverage

The traders are not required to deposit a full value of a position to open a position using CFDs. The deposit for just a portion of the full value of a security is called a “margin”. With this, CFDs are leveraged investment product. In leverage, it increases the effects (gains or losses) of price change in the certain security for investors.

Terms Related to CFD Costs

·         Commission Charges

Fees that CFD brokers often charge for the trading of shares.

·         Spread

It is the difference between the bid and asks prices for a security. Traders must pay a little higher ask price when buying and accept a little lower bid price when selling. Therefore, spreads represent a transaction cost to the trader because the bid and ask price differences must be subtracted from the total profit or added to the total loss.

·         Market Data Fees

These are broker-related costs that are charged for exposure to CFD trading services.

·         Holding Costs

These are charges on the open positions a trader may collect at the end of the trading day. They can be negative or positive depending on the spread direction.