Contract For Difference
An instrument for Speculative Investors and Traders
Investors have numerous possibilities to act on financial markets. CFDs are a somewhat speculative instrument. What is behind the abbreviation, and what do these instruments stand for?
CFD means Contracts for Difference. With the help of CFDs, investors participate in the development of the price difference of an underlying asset. CFDs can be based on various securities, such as stocks, indices, currencies, commodities, and special forward contracts (futures). The underlying asset is not physically traded but only a contract. With CFDs, both price directions of the underlying can always be traded. Investors can go “long” on the expectation of rising prices or “short” on a decline.
Profit and loss depend, of course, on whether the direction of the trade was correct. Those who assume that the Amazon share price will fall can bet on falling prices with a short CFD and profit from it. CFDs, as “Contracts for Difference” suggests, are about the difference between the buying and selling price. Gains and losses are always realised when the position is closed.
An essential feature of CFDs is the so-called leverage or leverage effect, with which a higher position value can be moved speculatively. For example, if you want to trade Shoprite shares for R10,000, you can achieve the same effect with CFDs and a leverage of 5 while only paying R2000 into the trade. For this purpose, a so-called security deposit is deposited with the CFD, the so-called margin.
A share of company ABC costs R100, and the investor wants to participate in the performance of the share with a leverage of 10. He is willing to invest R500, so his capital investment is just R500. He could buy 5 ABC shares with it; however, his position is unleveraged and just a regular capital investment. To participate with a lever of 10 in the price development of the ABC share, the CFD-buyer deposits the R500 as a margin and buys R5,000 worth of ABC shares, which means 50 contracts. If the share rises by 20 percent to R120, the long CFD position obtains a profit of R1000: 50 ABC shares as CFD times R20 profit. With a margin of R500, the investor receives a gain of 200 percent with an initial investment of R500. If the ABC share should lose 20 percent, losses result to the same extent.
However, high leverage can cause significant fluctuations in the deposit or CFD account. While blue chips often fluctuate little, this fluctuation multiplies rapidly upwards with leverage, often into double digits. In the negative case, the effect also works against the investor, who may then have to realise high losses. Leveraged trading with CFDs makes it possible to enter a higher position value than conventional spot trading in the underlying. Let’s say you want to open an Apple position with 500 shares. You would have to pay the total share price with a traditional investment. With CFDs, however, you have to deposit less, for example, only 20 percent as a margin.
The position is usually closed if a position’s loss reaches the margin amount. In CFD trading, there is a so-called margin call. Especially in the case of significant price jumps and so-called “gaps,” i.e., price gaps or price jumps that often occur overnight, such a scenario can occur.
Advantages of CFD trading:
- Investors can trade various underlying assets, which is often difficult to replicate. In addition to shares, commodities or currencies are available.
- The trading hours in CFD trading offer great opportunities for active traders. Especially currencies or indices are traded almost 24/7.
- In the positive case, leverage can increase the yield. Those with limited capital can use leverage but should consider the loss possibilities.
- Through the leverage of a CFD, one can profit from even small price movements. While with a share, a profit of 1 or 2 percent is only slightly reflected in the portfolio result, this profit multiplies with CFD trading. Thus, CFDs are particularly interesting for short-term-oriented traders.
Disadvantages of CFD trading:
- While one can theoretically remain indefinitely invested in a stock, the deposited margin limits the commitment in leveraged trading with CFDs. One must add capital or close the investment if the position runs against the desired direction.
- High leverage can quickly overwhelm private investors. In a negative case, one is confronted with high losses, which are psychologically burdensome.
- Many underlying assets are traded almost 24/7. This means a position can also run in an undesirable direction at night.