Contracts for Differences (CFDs)

Contracts for differences (CFDs) are what traders would define as a leveraged derivative financial vehicle. CFDs are considered derivative products because their benefit is derived from the value of an underlying asset rather than inherent. 

When a trader trades CFDs they are placing a bet on the change in price of the underlying asset over a definitive period of time. Again, the trader is wagering on whether the price of the underlying asset is going to increase or decrease in the future.

Most CFD brokers/marketmakers (iFOREX fx, fxcm,Plus500, Avatrade etc.) allow the trader to either go long or short the CFD. When going long and buying the CFD the trader hopes that the underlying asset will rise in price. In contrast, when going short and selling the CFD the trader is hoping that the underlying asst will decrease in price. In both instances, when the trader closes the contract, they are aiming to gain the spread between the closing price and the opening price.

An example of how a CFD works would be a trader purchasing the CFD over/covering company XYZ’s shares. If the value of XYZs shares increase and the trader closes out the CFD contract, the trader on the other side of the CFD (the seller) would have to pay the buyer the difference in the current price of XYZ shares and the price when the contract was initiated. On the other hand, if the shares of XYZ decrease in value the trader would be required to pay the spread in value to the seller of the contract. It is important to note that if the shares of XYZ Company fall that the trader could potentially lose his/her shirt. When a trader purchases CFDs they are leveraging off the money he/she originally put up for the trade. CFDs do not have an expiration date similar to options and or futures contracts. The only way a trader can close a CFD contract is if he/she makes a second reverse trade.

CFDs are different from trading the shares in XYZ Company in several ways. When you are trading CFDs you are not purchasing or trading the security directly. The CFD represents the purchase of a contract between the trader and the CFD provider. The trader when purchasing a CFD is under the impression and should hope that the provider is on sound financial footing and will have the ability to meet their trade obligations. The trade between the trader and the CFD provider is what is deemed a counterparty risk.

The trader should always keep in mind what he/she is willing to risk when trading CFDs. Because of the risk and complexity of these vehicles CFDs typically do not suit the needs and goals of most retail investors. When utilizing CFDs the trader is putting themselves at a high degree of risk which can ultimately wipe them out.

Some risks that are attributed to CFDs are investment risk, client money risk and execution risk.

In closing, CFDs are financial vehicles which allow the trader to leverage their trades and allow then to earn a significant amount of money. It is important to realize that the pendulum can swing in either direction regarding gains or losses. A trader must understand their risk to reward ratio when working with CFDs as a financial vehicle.

Image source: investopedia

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