Contract for difference is a favourite type of derivative product that enables a trader to speculate on or hedge on movements of equity indices and commodities. It does not need one to physically own those assets. This means that marketers do not need to pay some of the associated costs of ownership like account management fees and commissions and in some countries tax. CFDs are tradable instruments that mirror the movement of the assets underlying it. It allows the realisation of profit and losses when the underlying assets move about the positives taken, but one does not own the underlying asset.
CFDs originally started in the early 1990s as a type of equity swap that traded on a margin. Brian Keelan and Jon Wood widely take the credit of inventing CFDs. The CFDs were used by hedge funds and institutional traders to hedge cost their exposure to stocks in the London Stock Exchange market mainly because they only required a small margin and because no physical shares changed hands hence avoiding the UK tax stamp duty.
CFDs essentially is a contract between the trader and the broker. The price at which a dealer buys the CFDs, and the price they sell it, plus or minus any finance charges determines the merchant’s profits or losses from a CFD trade. The Contract for Difference trade has several significant advantages which have increased the popularity of the instruments over the years. The benefits are:
- The contract for difference business offers the trader leverage which gives the operator the ability to enter into CFD contracts using funds that represent only a fraction of its actual value. However, it is important to remember that leverage in CFDs like in other types of trades is a risk factor that can amplify both the positive and the negative results. When a trader uses force with caution, it can increase the traders potential based on the full amount of trade
- CFDs presents traders the opportunity to trade in a variety of markets and a range of instruments, including foreign equity indices and commodities. This ability to invest in different businesses helps the traders diversify their trading portfolio.
- CFDs do not require merchants to own the underlying equity index or commodities. The advantage to this structure is because the dealer carries no risk of having to take possession of the underlying physical instruments.
- CFDs do not have fixed lot requirements. The flexible order gives traders greater control in sizing their trade positions.
- Availability to buy on margin which will enhance the merchants trading capital
- Lack of taxes and hidden commissions which result in cost reduction.
Some of the risks involved are:
- The availability of trading on margin not only increases the extent of profits but also of losses. Therefore the trader should place stop loss orders to escape significant losses in case the position moves against the trader.
- It is riskier for long-term investors to hold a CFD open over a long time as the costs may increase and it would be more beneficial to have bought the underlying asset.
- CFDs can trade with relatively high leverage, and even a small change in the market can have a significant impact on your trading returns. If the change is in a negative way, the trader may have to deposit additional money to maintain his open positions and avoid an automatic margin closeout. People trading in CFDs are advised to keep extra money in his account to cover any adverse movements in the market.
- The CFD market is not highly regulated. Hence it is important to investigate whom you are dealing with in a trade.
One starts CFDs by making an opening trade on a particular instrument with the CFD provider. This creates a position in that instrument. There is no expiry date, once they close an area, the difference between the opening and closing trade is paid for profit or loss. CFDs trading is on margins and traders must maintain the minimum margin levels at all times. CMC markets are market leaders in CFD traders who have the knowledge and experience gained over two decades; this enabled them to build an award winning innovative platform which provides clients with world leading experience
