CFDs: what are contracts for difference and how do they work

What are contracts for difference (CFD)? And how do they work? This tool has circulated in the trading world for years, with many outlining their advantages and risks.

The main characteristic of contracts for difference is, of course, the difference. Specifically, the difference in an asset’s present value compared to when it was purchased. The buyer is paid (or pays) the difference between these two values.

Traders and investors use CFDs to profit from price movement without owning underlying assets.

For example, CFDs can be used to trade Apple shares once the stock price increases, even though the buyer does not own shares directly. This is possible thanks to a contract between the buyer and the seller (or, in other words, the client and the broker) without directly accessing the asset.

CFDs can cover any security, from currencies on the Forex market to commodities; from futures to, of course, regular stocks.

For this reason, understanding what CFDs are is a crucial step for any novice trader, especially if they want to be profitable in their activity. That is not to say, however, that CFDs are suitable for every investor and, indeed, they might not be the right fit for some.

Therefore, let’s delve deeper into what CFDs are.

CFDs, at a glance

• CFDs (contracts for difference) are legally binding contracts between a broker and an investor;
• The main objective of CFDs is to bet on the difference in the value of a financial asset at the time of signing and closing of such a contract;
• CFD investors do not actually own the financial asset, but still benefit (or lose) from its change in value;
• The main advantage of CFDs is their comparatively low price compared to the same asset in the traditional market;
• The main disadvantage of CFDs is the immediate decrease of the investor’s initial position because of the entry spread and/or possible lack of liquidity.

What are CFDs

CFD or Contract for Difference are derivative instruments that are used to trade financial products without actually owning them. In short, buying stocks may be difficult due to their high price, possible unavailability, or paperwork.

This is where CFD come in: thanks to them, every trader can enter into purchase or sale contracts with his own broker or intermediary, at the time and in the ways that suit him best. It should be kept in mind that with CFDs the trader does not really own the chosen financial asset, but is in possession of a contract with the broker which exactly replicates the quotation of the reference product.

Briefly, these instruments are defined as Contract for Difference because the traded instrument (share, index, etc.) will be traded according to real market conditions and the gain (or loss) will exactly reflect the difference between the price of purchase and sale price of the financial product, exactly as happens on the stock exchange.

How do CFDs work

CFDs give the buyer the opportunity to speculate on future market movements of a given underlying, without owning the underlying itself such as shares, commodities, and foreign exchange.

How do CFDs work? Essentially the operation is divided into two specific parts:

• opening of the position by the trader/investor
• closing of the position by the CFD provider through the reverse operation compared to the purchase one.

More specifically, if the opening transaction involved a long position (purchase, with the aim of speculating on the rise in the price of the asset), upon closing the position the broker proceeds with a reverse transaction, i.e. the sale. On the contrary, if the first position is short (of sale, with the aim of speculating on the fall in the price of a specific asset), the purchase by the supplier will take place when the contract is closed.

The profit is calculated on the difference in price between the opening and closing trade, net of any fees or interest.

The advantages of CFDs

CFD have considerable advantages which explain why this instrument is so successful among traders and is spreading with an increasing trend:

• allow investors to maximize their initial purchasing power thanks to financial leverage, which allows them to trade products with small sums;
• allow investors to generate profit both when the market is rising and when it is falling, since it is possible to [operate both long (buy) and short (sell). Warning: these operations are to be considered risky and capable of generating losses for the trader, especially if he is not familiar with the broker or instrument with which he has chosen to trade;
• it is possible to trade CFDs on stocks, stock indexes, currencies, commodities and much more.

The risks of CFDs

Trading with CFDs means entering an environment that is very fast and requires constant monitoring and it is essential that the trader is well informed about the risks that contracts for differences bring with them:

• It is possible to encounter situations of low liquidity, for this reason, it is important to rely on a well-known and established broker;
• It is necessary to maintain large margins in order not to incur unscheduled closures of one’s position;
• It is possible to record losses, which the investor is obliged to pay to the broker;
• Leverage, in addition to maximizing gains, also maximizes losses in the event that the market moves contrary to the trader’s expectations.

Investing in CFDs: a practical example

To fully understand how CFDs work, we can use a practical example. Let’s say a trader carries out an analysis predicting an appreciation of Alphabet shares from $165 to $200: he will need to shell out $165 to buy a single share and attempt to make a $45 profit, in case his analysis proves to be exact, except for commissions. This is provided that someone is willing to sell him a single share.

Thanks to CFDs, on the other hand, there is no constraint on the share price (and any multiples thereof) and the trader can decide at any time the amount to invest himself, also having the possibility of limiting himself to much lower sums while amplifying any gains through the use of leverage.

Let’s take a another example, more technical.

Suppose a share has an asking price of $20.56 and the trader buys 100 shares. The cost of the transaction is $2,056 plus any costs and commissions. This operation, if reference is made to one of the traditional intermediaries that require a 50% margin, will require available liquidity of $1,028. Instead, most of the online brokers that offer the possibility of trading with CFDs require a 5% margin, which in our example corresponds to $102.8.

When the position is opened, a loss equal to the size of the spread at the time of the transaction is recorded. If the spread is 5 cents, the stock must gain 5 cents for the position to break even. If the shares were compressed in practice, the investor would have already recorded a profit of 5 cents, but they would also have had to pay a commission and would have been forced to immobilize a greater amount of capital.

If the stock rises and reaches $21.31 (bid price on a traditional account), a profit of $75 is made on the sale, with a gain of 7.29% ($75/$1,028).
However, when the security reaches this price on the exchange, the bid price of the CFD will not be higher than $21.29. The profit will be lower because the trader has to exit the position at the bid price and the spread is higher than in the normal market.

In the case of trading with CFDs and in the case of our example, the profit will not be $75 but $73, for a return on investment of 71% (73/102.8).

CFD brokers, however, often charge a higher purchase price, which reduces the profit at the close of the contract, but it still remains clear that, in the example above, the CFD trader gains more from the same market dynamics than the investor who physically bought the shares.

CFD: what’s the difference with ETFs

It is normal to wonder whether it is better to invest in CFDs or ETFs. The answer depends on the objectives of the trading strategy: usually investors look for the right balance between risk and economic return, but to achieve it they must become expert traders and carefully evaluate which instrument is best suited to them.

What are ETFs?

ETFs are funds or SICAVs that closely replicate the performance of an asset or a basket of assets, bonds, commodities, cryptocurrencies, or other asset classes.

This means that the price can fluctuate throughout the day, just like stocks, and that ETFs can be used by traders to try to make short-term profits, although they can also incur large losses.
They are also funds, therefore suitable for long-term investments, and can be based on many different underlying: stock indices, commodities, bonds, currencies, etc.

CFDs were born after ETFs. They allow investors to have a contract to receive or pay the price difference derived from the investment time period, i.e. from the moment the position is opened until the moment it is closed.
Investors get the same benefit as a real shareholder from the price increase, but without buying the underlying asset - which saves investors some costs and bureaucracy.

ETFs and CFDs have many differences. CFDs are derivative assets, providing leverage to control and profit (or lose) from a price change. Investors are significantly more exposed to the market than with normal minimal capital. On the other hand, ETFs are designed to reduce risk and increase diversification, thereby reducing investors’ exposure.

Moreover, CFD investors usually need between 5% and 10% of the value of the underlying asset to produce effective liquidity, while ETFs must be bought and sold at full price like regular stocks.

After reading this comprehensive guide on CFDs, novice investors will be able to try themselves on demo accounts. Unless, of course, the risk is too much for them.

Original article published on Money.it Italy 2023-04-25 14:12:02. Original title: CFD: cosa sono i contratti per differenza e come funzionano