Contracts for Difference

Using CFDs for Hedging Purposes

If a stock market investor owns stock but fears a price fall in the short term, he can use a contract for differences to cover the risk.  To do this the investor will open a short position on a contract for differences on the same stock.  The effect of this CFD trade will be to offset any losses that might be incurred on the stock; i.e if the stock position goes down in value the short CFD contract will move into profit territory.  However, this CFD trade will also have the effect to putting the trader into a market-neutral position.  If the stock quotation grows, the contract for differences will record a loss, equivalent to the stock profit.

Contracts for Difference are Zero-Sum

From a practical perspective, the market of contracts for differences is a zero-sum game. This situation is specific for futures transactions. The profits made by some of the participants are always matched by corresponding counter-parties that record a loss.  If the total market doesn’t have a profit or loss, for participants each profit hides the loss of one of the investors.

CFDs: Good Choice for Short-Term Investments

Contracts for difference are a good choice for short-term investment. The possibility to trade very cheaply, via a simple mechanism of trading and permanent marking-to-market make the CFD perfect tools for short-term speculators. For longer investment horizons CFD investments may not always be the best choice since the leverage effect requires a permanent surveillance of the investment and also because of the financing costs that are incurred on a daily basis.  For long-term holdings, risk management can emphasize safer investments such as stocks or for the individuals in contributions to private pension funds.

Not Suitable for All Investors

Finally it should be pointed out the fact that the investments in CFD aren’t suitable all investors as there are a number of trading risks with CFDs .  Depending on the investor’s risk appetite, investment time horizon, time available to trading and his interest in the stock markets, one can make an informed decision on whether CFDs are an appropriate instrument to use.  The increasing popularity of derivatives trading is allowing the market to grow and providers to keep expanding their investment products   If the purpose of trading derivatives is speculation, the investor should not forget that the leverage great when it generates profits but can also be painful when it produces losses.  If a potential investor on financial derivatives market does not take into account the possibility of losses, he is probably better off participating on a traditional market where the price, paid to initiate a transaction, limits the risks and profits.

(copyrighted to Andy Richardson July 29, 2010)