A Contract for difference (CFD) is an agreement between a ‘buyer’ and a ‘seller’ to exchange the difference between the current price of an underlying asset (shares, currencies, commodities, indices, etc.) and its price when the contract is closed.
CFDs are leveraged products. They offer exposure to the markets while requiring you to only put down a small margin (‘deposit’) of the total value of the trade.
They allow investors to take advantage of prices moving up (by taking ‘long positions’) or prices moving down (by taking ‘short positions’) on underlying assets.
When the contract is closed you will receive or pay the difference between the closing value and the opening value of the CFD and/or the underlying asset(s). If the difference is positive, the CFD provider pays you. If the difference is negative, you must pay the CFD provider.
CFDs might seem similar to mainstream investments such as shares, but they are very different as you never actually buy or own the underlying asset.
We are including a practical example on how CFDs work compared to investing in a share.
Option 1: Buying Common XYZ Stocks
- The Price of XYZ’s stock is $150
- Investor A intends to buy 1000 stocks
- He will invest $150,000
Option 2: Buying CFDs on XYZ Stocks
- The Price of XYZ’s Stock CFD is the same with the underlying asset ($150)
- Only a margin of the Nominal Value of the Stock’s Value is required (10%)
- What is the Cost of buying 1000 CFDs? It would be $15,000
Best Case Scenario: XYZ’s new phone hits record sales and by the end of the week its stock rises 10%!
Who invested under Option 1: New price of stock is $165. Profit of each stock is $15…
Who invested under Option 2: New price of CFD is $165. Profit of each CFD is $15…,
The total profit made would be $15,000 under each option however percentage wise it would be 10% of the capital invested under Option 1 and 100% under Option 2.
Worse Case Scenario: XYZ’s new phone debut disappoints and the stock’s price by the end of the week is down 10%!
Who invested under Option 1: New price of stock is $135. Loss on each stock is $15
Who invested under Option2: New price of CFD is $135. Loss on each CFD is $15
The total loss made would be $15,000 under each option however percentage wise it would be loss of 10% of the capital invested under Option 1 and 100% under Option 2.
Key Message
CFDs are complex products and are not suitable for all investors.
Don’t use money you can’t afford to lose. You could lose much more than your initial payment.
You should only consider trading in CFDs if:
- you have extensive experience of trading in volatile markets,
- you fully understand how they operate, including all the risks and costs involved
- you are aware that the greater the leverage, the greater the risk,
- you understand that your position can be closed whether or not you agree with the provider’s decision to close your position,
- you have sufficient time to manage your investment on an active basis.
