A Contract for Differences (CFD) is an arrangement made in a futures contract whereby differences in settlement are made in the form of a cash payment. There is never any obligation for any part to deliver actual physical goods, securities, etc when the contract expires. Both losses and gains are paid in cash.
If you want to engage in CFD trading, there are plenty of CFD brokers available online. There are a number of different website out there that can help you decide which broker suits your needs. You need to chose a broker with a good reputation that offers trade based on the assets you want to trade with.
Contract for Differences (CFD) can be based on a variety of things, such a shares, currency pairs or commodities. It can even be based on indices.
With a CFD, you can profit from the increased market value of a share, currency, commodity, or similar without actually having to own in. Instead of purchasing shares in a company, you purchase a CFD. Instead of actually owning pound sterlings or sign up with an FX broker online, you purchase a CFD, and so on.
For some stock companies, purchasing even one share is out of the question for the hobby trader. One extreme example is Berkshire Hathaway Inc, a company that doesn’t split their shares. At the time of writing, the market price for one Berkshire Hathaway Inc Class A share at the New York Stock Exchange (NYSE: BRK.A) is 214,900 USD.
So, what can you do if you believe that Berkshire Hathaway is going up, but doesn’t have $200,000+ to invest? You can purchase CFD:s that will make your profit from an increase in BRK.A share price.
There are CFD:s available that will mimic the underlying share in various ways. You don’t get any voting rights, but you can definitely find CFD:s that will pay you money when the stock company distributes dividends and CFD:s that participate in stock splits.
Another advantage with CFD:s is that you can use them to gain exposure to markets that would be difficult or prohibitively costly for you to enter directly. e.g. stock companies in certain foreign countries.
Example
The current price of ConocoPhillips on the New York Stock Exchange (NYSE:COP) is $40.10. You believe that the price will rise higher soon and you want to profit from that. If you buy 100 shares using your online stock broker, that’s $4,010. You have a margin account, but the margin requirement is 50% so you would need to pay $2,005 upfront.
You check out what your CFD broker has to offer. With this broker, the margin requirement is only 5% which means that you only need to scrunch together $200.05 – the remaining 3809.95 you can borrow from the broker.
You decide to buy CFD:s, but when a CFD trade is entered, the position will show a loss equal to the size of the spread. So, if the spread for this particular deal is $0.08 the NYSE:COP must rise by 8 cents just for your position to reach break even point. If you ha actually purchased 100 shares in COP, an 8 cent price increase would translate into a $0,80 value increase for your position. You would on the other hand most likely have paid a rather hefty fee / commission to your stock broker.
Disadvantages
CDF:s are not suitable for long-term investing if holding the CDF will cost you money day-for-day.- The spreads tend to be quite big. Paying the spread on entries and exits can prevent you from profiting from small moves. Also, paying the spread on entries and exits can decrease your profit on winning trades and increase your losses on losing trades (compared to trading in actual stocks, commodities, etc).
- The CFD industry is not highly regulated, especially not compared to the level of regulatory protection offered by major stock exchanges.
Costs
- With most CFD brokers, no fee is charged for trading a CFD. Instead, the broker makes money from traders paying the spread. The trader buys the ask price when buying and receives the bid price when selling or shorting.
- The CFD market is typically without short-selling rules, and instruments may be shorted at any time, and since there is no ownership of the underlying asset there is no borrowing or shorting cost.
Leveraged CFD trades
Leveraged CFD trades are very common. The margin requirement will vary from one broker to another. Individual traders can also be offered different margin requirements from the same broker, and how much you wish to borrow can also impact the percentage. Anywhere from a 2% to 20% a margin requirement is considered pretty normal within the CFD industry.
No daytrading thresholds
If you are interested in small-scale daytrading you might find CFD:s a better option than stock trading, simply because so many brokers will only allow daytrading for clients whose capital is large enough to reach above a certain threshold. Limits on the amount of trades that can be made within a single trading day are also quite similar. With CFD:s there are usually no such requirements.