Contracts for Difference (CFD)
Contracts for difference (CFD) are contracts that obligate either the buyer or the seller to pay to the other the difference between the asset's current price and its price at the time of the contract's usage. If this difference is positive, then it is the buyer who needs to pay it to the seller, but if this difference is negative, then it is the seller who needs to pay it to the buyer. For example, if a CFD on a stock share is purchased when the share is priced at €20 and then used when the share price has risen to €24, the seller pays the buyer the €4 difference. If the share price had instead fallen to €18, the buyer pays the seller the €2 difference.
The price at which a particular CFD contract is traded and the price at which it is valued depends on the underlying asset. The underlying asset could be a bond, a currency, a commodity, an index or an equity.
A listed company share is trading at €10 per share. An investor could buy 10,000 shares at a cost of €100,000. One of the attractions of trading CFDs is that they are traded on margin. Margin is the collateral that must be paid to the broker to use the CFD exchange. The investor does not have to pay the full cost of the underlying asset i.e €100,000. If the margin is 10%, the Investor can acquire the CFD position for €10,000. If the Investor believes the listed company share will increase in value, they acquire a “long” position and buys 10,000 CFDs. If the Investor believes the listed company share price will fall, they acquire a “short” position. The CFD broker requires a 10% initial margin payment, so the Investor pays the broker €10,000 to take the position.
When the Investor decides to close their “long” position, if the listed company share is trading at €12 they crystallise a gain of €20,000 (€12 - €10 * 10,000 CFD’s).
Conversely, a loss can be crystallised if the share price had fallen. For example, if the share price had fallen to €7, the Investor would have made a loss of €30,000 (€7 - €10 * 10,000 CFD’s).
In this case the Investor’s loss would have exceeded the collateral margin paid of €10,000 and the Investor would have to pay the broker an additional €20,000 to close their position. This is known as a “cash call”.
There are further costs in using CFD’s. In the example above, the broker is making a notional investment of €100,000 and the Investor is only paying the margin of €10,000. The CFD broker will charge for financing.
The interest expense associated with a long position is usually tied to a benchmark market rate.
Some brokers may also charge commission or stock lending fees.
Trading in CFD’s is only recommended for experienced investors. The advantages are the lower initial outlay to take a position and the ability to take a position where an investor believes a price will fall (i.e. a “short” position). But the associated costs and the potential for cash calls are risky.
If the underlying asset, be it currency, shares, bonds, crypto are volatile regarding pricing, the movement in the value of the CFD is high compared to the initial outlay.