Trading 101: What are Contact for difference?

A forex CFD is a contract for difference. It is an agreement between two parties to settle the difference in the value of an underlying asset between the point at which they entered into the trade and its expiry or settlement date.

Why are CFDs popular?

The main appeal to CFDs comes from their ability to be utilized as leverage trades, allowing traders to borrow money from brokers to increase their exposure to the market – with an appropriate amount of capital being required, equal to 100% of the notional value (or total sum borrowed).

This provides traders with a lot more ‘bang for buck’ compared with regular currency trading, where there is no leverage available. For example, if you were to enter into a GBP/USD CFD trade with a leverage of 100:1 on a notional value of $1,000.00; your initial deposit would only be $1.00 in comparison to traditional currency trades where you could have been required to put up anywhere between 50% and 80% of the total cost of the position being taken.

Benefits

CFDs provide traders with the ability to speculate on price movements in either direction and are traded according to price fluctuations rather than time, as is the case when trading futures or forward contracts (forward contracts, like swaps, are very similar instruments to CFDs but differ from them in that they do not settle via cash payments at set intervals throughout their life cycle). It is also possible to close CFDs before their expiry, in a process known as ‘rolling over,’ which can be performed on the London Stock Exchange (LSE) Equinix platform via the Broker Service Providers (BSPs).

While the offsetting of long and short positions is responsible for providing traders with leverage, it also means that traders are exposed to risk if the market moves in an adverse direction – therefore, diversification and hedging strategies are required.

Following the global financial crisis of 2007–2008, there has been an increased interest in cash-settled instruments like CFDs based on financial indices such as stocks, commodities, or bonds. Since these instruments do not involve buying or selling physical amounts of the underlying asset, they can be traded in multiple ways using CFD trades.

Process

CFDs are bought or sold against a broker-dealer; the buyer and seller agree on a price, which forms the basis for potentially huge gains if either party were to close out their position before expiry. In some cases, this may also lead to massive losses if leveraged long positions are mistakenly entered at too high a level, causing you to lose more money than your initial deposit actually contains (i.e., your account balance). You can take a help of a broker like cm trading for this process.

Unlike fixed-return instruments like options or futures, traders can only profit from price movements in either direction (long or short) – the CFD will expire worthless if the underlying asset’s price stays steady at expiry. CFDs are often traded on margin, meaning that you only need to deposit a certain percentage of the total cost of your position as collateral against potential losses to enter into trades that could theoretically be worth many times more than your initial investment.

Fidel Hamill