What are Contracts for Differences?

CFDs (Contracts For Difference) add another aspect to your trading strategy, they are leveraged trading products meaning you can ‘buy’ a quantity of shares for substantially less money than buying physicals, or ‘buy’ substantially more than you would normally be able to, or want to! You never physically ‘own’ the shares but receive dividends as if you did, similarly if you are ’short’ you owe any dividends payable.

So are CFDs similar to holding Shares?

A contract for difference is almost exactly like buying and selling the underlying shares but you do not get any voting rights or company reports. Moreover, the interest charges are different to savings accounts because it is normally LIBOR + X%. So it might end up costing you more in the long term to be LONG shares via a CFD than it would if you bought the underlying asset. But if you are a short term-trader this may make little difference.

Investors can benefit from CFD trading from an increase or decline in an instrument. For example:

Scenario 1: Profit from a Correct Anticipation of an Increase in a Share Price

A trader enters a contract to buy 2,000 share CFDs at $10 per share, equivalent to a long position of $20,000 The deposit requirement (aka margin requirement) for this position will be $2,000, based on the stipulated initial margin of 10%. In the circumstance that the share price goes up to $11 per share, the trader could close the position by selling the CFD making a gross gain of profit of $2,000 (excluding charges) in the process.

Scenario 2: Profit from a Correct Anticipation of a Drop in a Share Price

A trader enters a contract to sell 2,000 shares as CFDs at $10 per share, equivalent to a short position of $20,000. Again, the deposit requirement to open this position will be $2,000 (assuming a 10% margin requirement). In the event of a price decrease to $9 per share and a closure of the position through a purchase of the CFDs, the trader will make a gross profit of $2,000 (excluding charges) through his strategy of selling high and subsequently buying low.
Uses and Risks of CFDs

Popular trading strategies of contracts for differences include hedging an existing shares portfolio or hedging share options, taking a directional view of the market (ability to go long or short) and pairs trading. Trading in pairs involves going long in respect of, say, Anglos and shorting, say, Billiton’s, thus creating a portfolio that incorporates your view of different stocks within similar sectors, or an investor could even take a view on different sectors.

Through placing a comparatively small amount of margin with a CFD provider, the investor can obtain massive exposure to the underlying reference instrument. Thus the investor has a ‘turbocharged’ trading tool that he can add to his arsenal of weapons. For this reason when trading CFDs, the profit rewards can be significant when you compare the potential gains to the lower cost of entry. Equally so can the potential losses be significant if the investment price goes in the opposite direction.

CFDs in a Nutshell -:

1) A CFD is a DERIVATIVE, you do not own shares in the companies you take contracts on.

2) A CFD can be a leveraged product and they are called Contract For Difference because they are exactly what they say on the tin. You make (or lose) money on the DIFFERENCE in the price you open your contract and the value of the underlying asset.

example / If you went long on company XYZ shares with a CFD@£1.00 then you will make money for every penny XYZ shares move above £1.00 ie/ The difference. Conversely you will lose the difference for every penny they fall below £1.00

3) You can go LONG or SHORT at any time markets are trading unless there is a Short selling ban in place like earlier this year on financials.

4) CFDs do not expire.

5) If you go long, you pay interest on the CFD but you earn dividend payments.

6) If you go short you earn interest but pay out dividend costs.

(copyrighted to Andy Richardson July 22, 2010)