What Are Contracts For Difference (cfds)?

Contracts for Difference are a financial derivative – relatively new compared to other financial tools. The specific type of instrument is a derivative. Other financial derivatives include options, warrants and futures. A derivative is a tool that is taken from a valuable piece of property such as currency, bonds and stock. There is an agreement taken out against that asset between two different parties with an arrangement that one side pays the other the difference in price of that asset from time of purchase to time of sale.

CFDs are an arrangement taken between two sides, to pay the difference in the price of an asset from the time one purchases it to the time one sells it. The difference between the cost of the asset will be determined by changes in value from the original market.

CFDs are unique as a financial instrument as they can be created against any type of tradable financial asset. This includes currencies, bonds, commodities, energy, indices, stocks, property etc... It’s easy because it’s just the creation of a contract between two parties to pay the difference in the original value from the time you acquire it to the time you sell the contract. You don’t even need to own the asset.

CFDs can be created in both short and long positions. A short position is where the purchaser would have to pay if the price goes up and the seller pays if the price goes down. A long position is a position where the purchaser thinks that the value will go up. If the value goes up from the point of purchase, the person who sold the contract will have to pay the purchaser the difference in the price of the contract. The value of the contract is reflected directly by the price of the asset. If the price of the asset goes down, the individual who bought the contract would have to pay the person selling the difference in the price.

Contracts for difference are usually traded on a market run by single company, known as the market maker. They are not usually run where each contract is made between two different individuals. The market maker is the entity who facilitates the other end of the purchase. A trader is usually purchasing and selling to a single entity. Market makers earn a living by profiting off trades that go the wrong way, by charging on trades and by creating a spread on the CFD. The spread is the difference between the purchase price and selling price of the Contract for Difference. These entities also make money by charging investors interest.

CFDs are usually purchased on a margin. An example would be if you purchase $10000 worth of contracts, you would only pay $500 in cash, and borrow $9500 from the entity. The market maker will then charge you interest on long positions and pay interest on short positions. The cost is usually quite small, with you paying an extra 2-3% on the official cash rate for long positions and you receiving the official cash rate minus 2-3% for short positions.

The great part about having a margin is that you can take out larger positions than you have the immediate cash for as you only need 5% (depends on the market maker) of the actual value of the trade to create the contract. The risk is that if the trade doesn’t go as predicted, the costs can be very large.

By: Vincent Z Parker

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123CFD is an educational site explaining contracts for difference (CFDs).