A contract for difference (CFD) is an arrangement made in financial derivatives trading where the differences in the settlement between the open and closing trade prices are cash-settled. CFDs are essentially used by investors to make price bets as to whether the price of the underlying asset or security will rise or fall.
The buyer will offer their holding for sale if he sees the asset's price rise. The difference between the purchase price and the sale price are netted together. The net difference representing the gain or loss from the trades is settled through the investor's brokerage account.
An opening sell position can be placed if a trader believes that a security's price will decline. They must purchase an offsetting trade to close the position. Again, the net difference of the gain or loss is cash-settled through their account.
Advantages of a CFD
CFDs provide traders with all the benefits and risks of owning a security without actually owning it or having to take any physical delivery of the asset.
CFDs are traded on margin. The broker allows investors to borrow money to increase leverage or the size of the position. Brokers will require traders to maintain specific account balances before they allow this type of transaction.
Trading on margin CFDs typically provides higher leverage than traditional trading. Standard leverage in the CFD market can be as low as a 10% margin requirement and as high as a 50% margin but it can vary significantly by broker. Lower margin requirements mean less capital outlay and greater potential returns for the trader.
Few or no fees are charged for trading a CFD. Brokers make money from the trader paying the spread. The trader pays the ask price when buying and takes the bid price when selling or shorting. The brokers take a piece or spread on each bid and ask price that they quote.
Disadvantages of a CFD
The spread on the bid and ask prices can be significant if the underlying asset experiences extreme volatility or price fluctuations. Paying a large spread on entries and exits prevents profiting from small moves in CFDs, decreasing the number of winning trades and increasing losses.
CFDs trade using leverage so investors holding a losing position can get a margin call from their broker. This requires that additional funds be deposited to balance out the losing position. Leverage can amplify gains with CFDs but leverage can also magnify losses. Traders are at risk of losing 100% of their investment. The trader will also be charged a daily interest rate amount if money is borrowed from a broker to trade.
Example of a CFD
An investor wants to buy a CFD on the SPDR S&P 500 (SPY), an exchange-traded fund that tracks the S&P 500 Index. The broker requires 5% down for the trade.
The investor buys 100 shares of the SPY for $250 per share for a $25,000 position from which only 5% or $1,250 is paid initially to the broker.
Two months later the SPY is trading at $300 per share and the trader exits the position with a profit of $50 per share or $5,000 in total.
The CFD is cash-settled. The initial position of $25,000 and the closing position of $30,000 ($300 * 100 shares) are netted out and the gain of $5,000 is credited to the investor's account.
Source: Contract for Difference (CFD) Definition, Uses, and Examples, accessed 12 June 2024, <https://www.investopedia.com/terms/c/contractfordifferences.asp>
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