Derivatives: Contracts for Difference
An Easy Derivatives Tutorial
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Contracts for Difference are a form of financial derivative that allow holders to speculate on price movements of underlying assets without actually owning those assets.
A contract for difference (or CFD) is a contract between two parties, buyer and seller, stipulating that the seller will pay to the buyer the difference between the current value of an asset and its value at contract time. (If the difference is negative, then the buyer pays the seller. If the contract is "short" these movements are exchanged.) (http://en.wikipedia.org/)
CFDs are available on individual stocks, major stock indices, stock sectors (eg construction, banks etc), foreign exchange currency pairs, gold and silver. CFDs are not time limited, ie they have no expiry date.
Brokers make their profit through the spread in buy/sell prices and/or a percentage commission charged on deals.
Uses of CFDs
- CFDs are traded on margin. Typically only 5-10% of the amount traded needs to be deposited with the broker up-front. This means percentage gains (or losses) in the price of the underlying are magnified.
- CFDs allow "shorting", ie they allow profit to be made from falling prices.
- CFDs may be used to hedge a position, eg someone with a long term holding of IBM expecting a temporary setback in the share price could use a CFD to short IBM. For the duration the CFD is held no loss is sustained, whichever way the stock moves (profit is also forgone).
Risks of CFDs
CFDs are a leveraged instrument, thus significant losses can be incurred in proportion to stake. In the case of going short, potentially unlimited losses can occur should the price rise substantially. In practice stop losses are used to limit potential losses, but beware that where there is high price volatility and/or market "gaps", stop losses are not guaranteed.
NB some brokerages offer limited risk CFD trading. These offer GUARANTEED stop losses. The additional risk carried by the institution is reflected in a wider spread (difference in buying and selling price).
As CFDs are traded on margin, they involve money being borrowed or lent, and as such interest is payable (on long positions) or received (on shorts). This interest is calculated on a daily basis and is usually linked to some standard rate such as LIBOR. Beware, it is paid at a little less than this rate and charged at a little more.
Dividends are received on stock CFDs held long, and must be paid on stock
CFDs held short. Bear in mind that when stocks go "ex-dividend"
the share price generally falls by approximately the amount of dividend,
thus the effect of short CFDs having to pay is more or less discounted
by the gain in contract price.