Contract for Difference (CFD)

The term “contract for difference”, or "CFD" describes a financial product belonging to the broader group of so-called total return swaps. Swaps, in turn, fall under the more general category of derivatives.

In financial jargon, trading in contracts for difference is referred to as CFD trading. It does not involve trading in actual underlying assets. Instead, CFD traders speculate on the development of an underlying asset’s value. Stock CFDs, in which stocks provide the underlying value, are based on the development of specific stock rates rather than actual stock trades.

While stocks are frequently used as the underlying asset, a broad range of assets can be used as underlying assets in CFD trading, depending on the stock broker. These may include bonds, currency, commodities, precious metals and futures. CFDs can even be fixed to market indexes, such as the Swiss SMI.

A CFD can be compared to a bet, in which you speculate on a hoped-for development in rates. You can bet not only on rate hikes, but also on rate drops. When an investor aims at making a profit on climbing rates, it is referred to as long trading. On the other side of the coin, short trading describes making a profit on falling rates.

Trading in contracts for difference is exceptionally affordable, but it also involves a large amount of risk. That is because of the leverage effect employed by CFDs. The leverage employed is of key importance in derivatives trading and indicates the potential gain or loss you could incur.

The leverage effect is explained in this example: The rate of a stock falls 3 percent in one day. If an investor had engaged in a long CFD with a leverage of 15, the losses would be 45 percent greater. An investor with a short CFD on that share would enjoy 45 percent higher returns.

When you buy CFDs, you as the investor only need to pay a small portion of the actual underlying value. The portion you invest is called the margin. In practice, margins normally range from one-fifth (leverage ratio of 5) to one-hundredth (leverage ratio of 100) of the underlying value. When you sell a CFD, only an agreed-on difference is paid, while its underlying value is not transferred.

CFDs do not have a fixed term, expiry date or size (unlike futures). Because CFDs are only dependent on rate performance and brokerage fees, they maintain a relatively simple product structure.

Still, CFDs are normally kept for short amounts of time, such as several hours, one day or several days. Theoretically, long-term strategies encompassing several months are possible. But in practice, CFDs are rarely held over long periods. One reason for this is that rates can change radically overnight. Another reason is that interest charges on leveraged assets apply when you hold CFDs overnight.

Unlike other derivatives, CFDs are not traded on the stock exchange and are subject to very little regulation. They are primarily offered as over the counter products.

Contracts for difference are one of the highest-risk investment vehicles available. Profits can be very high, but in the event of a loss, you won’t only lose the margin you invested, you may also be hit with further financial liabilities. The reason for this is that CFDs generally come with a payment obligation clause. In the worst case, CFD investors will have to make further payments out of their own pocket (this sets CFDs apart from leverage certificates, for example).

Because of the high risk of making a loss, CFD trading is not suitable for newbie traders. In the USA, trading in CFDs is forbidden altogether. Contracts for difference are especially popular in the United Kingdom, where it is estimated that as much as 25 percent of stock exchange volume is transacted through CFDs. In Switzerland, CFDs are not widely used.

More on this topic:
CFD trading: Compare and get free quotes
CFD fees and charges explained
CFD trading: The risks explained
CFD calculator: gain and loss
CFD calculator: stop loss and take profit

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