A CFD is a Contract For Difference. Much like it sounds, you can either profit or lose based on a difference in prices. The CFD is an agreement between someone who owns shares and someone who wants to profit from a share price move but has no desire to actually own the asset. This is how a simple CFD transaction would work.
Bob and Doug Make a "Contract For Difference"
Two friends Bob and Doug watch the stock market. Bob is into higher risk and big leverage while Doug prefers a more traditional investment method of dividend paying stocks. Bob usually dabbles in penny stocks but is sitting out of the market at the moment. Doug recently purchased 1 share of a blue chip stock worth 100 dollars. Bob gets an idea.
Usually, Bob does not deal with highly priced companies because the movements are relatively small compared to his appetite for risk and reward. With Bob’s idea he can get the best of both worlds.
"Doug, the market is unstable right now and I imagine you are somewhat nervous over what your share might do. Would you be willing to make a contract between the two of us where you continue to hold the share, but I will assume the market movement risk?"
"What do you mean Bob?"
"Well, if the share goes up I keep the profits. If the share price drops, I will pay you the difference. You see, it is a contract for difference."
Doug thinks for a moment. "Well I guess that eliminates my risk until the market stabilises. But I would need a little bit of profit since my money could also go in the bank. You will need to pay me a little fee. As well, I want you to give me 5 dollars as collateral or margin. You remember the last time you didn’t pay me."
Bob shakes his hand. "I agree. But remember, there is no expiry date on this contact. As long as I have the available margin, I can hold this contract indefinitely or just a day. Of course, I will pay your daily interest rate."
CFD’s are Leverage
It is clear that Bob is in a highly leveraged position where he can make a lot of money or lose much capital. Doug is in a very safe position whereby he is exposed to none of the risk from the fluctuating prices while the contract is in effect. A CFD is merely an agreement to trade future price movements, instead of owning the asset itself.
This is how a CFD compares to owning the asset, in this case publicly traded shares:
|Total capital outlay
||($12.00 x 1,000 shares + $19.95 broker fees)
||($12.00 x 1,000 CFD’s x 5% margin + $10.00 broker fees)
Why Trade CFD’s?
- High Leverage. Because CFD’s require low margin, often only 5%, the leverage can be 20 times or greater that of the asset holder. Remember though, leverage works both ways – sometimes for your profit, sometimes for your loss.
- No Need to Hold Asset. Taking up a large position with a security typically means driving the share price up due to sustained buying. Selling or liquidating a large amount of stock also drives prices down. This does not create competitive pricing. Purchasing CFD’s can circumvent this (if using a certain CFD provided by Market Makers as discussed later) by making an agreement directly with the asset holder without acquiring the shares, and bypassing the exchange in some instances. Other models will require putting your CFD in the trade book.
- No Expiry Date. Options have an expiration date whereby they are exercised or they expire worthless. CFD’s have no expiration date. This also means that they do not devalue over time, or suffer the ill effects of time decay. However, there are fees that need to be paid if held overnight.
- Dividend Payments. Interestingly enough, even though the CFD holder does not actually possess the asset, he does receive the dividend payment from it.
- Easy to Understand. Far too many investments available are so convoluted that you need a Masters degree in ‘discombobulation’ to decipher. CFD’s are extremely easy to understand. The CFD profit or loss is based on simple price movement starting with today’s price as a baseline.
- Ability to Trade Long or Short. CFD’s make it very simple to profit from a bull market or a bear market.
- Low Fees. Broker fees for futures, options, indexes, funds, and equity shares vary greatly. Some of the aforementioned investments can be quite costly to take a position in. CFD’s are quite economical as regards to broker fees and commissions. It can be as low as one-tenth of one percent, or $8 to $10 for some minimum fees.
- International Markets. Trading assets is often limited to the country in which one lives in. CFD’s has opened up that exclusive market to Australians by including many other areas such as the Europe and Asia.
Investing In CFD’s
With so many advantages attached with a Contract For Difference, they are definitely worth further investigation. The next lesson will deal with the two major types of CFD’s: Direct Market Access (DMA) and Market Making (MM).