What is a CFD?
A contract for difference (CFD) is an agreement between two parties to exchange the total difference in value between the price of a particular commodity at the start of the contract and the price when the contract is terminated. The popularity of CFDs is growing rapidly throughout the world; in part, because of the wide range of commodities that can be subject to this type of agreement. Specific currencies, commodities, stocks and indices can be the subject of a CFD, giving investors and investment banks the opportunity to diversify their portfolios and spread their risk.
How does a CFD work?
The amount payable at the end of a CFD contract will be the difference between the asset's current price and the price at the time the agreement started. If the trader buys long, and the share price subsequently rises in value, the buyer receives the difference in cash from the seller. However, if the asset should fall, the seller receives the difference. It should be noted that no restrictions on entry or exit price are imposed, and there is also no time limit imposed on the timing of the final exchange. So, because a CFD is traded on leverage, it gives individual traders a good deal more flexibility and trading power.
Entering into a CFD contract does not mean that the trader buys the shares associated with it - but the profit or loss made will be a direct result of the share price. Because traders never own the share, they will usually only pay a deposit on it instead of the full market value. It is therefore possible for traders in blue chip shares to pay as little a 5 percent, and that allows them to deal in CFDs worth far more than their initial capital. This system allows traders to secure some stunning profit margins with a relatively low exposure. For instance, a CFD that requires a 5 percent margin for trading will deliver a profit of 100 percent if the price of that share rises by just 5 percent. And with the markets being what they are, a 5 percent increase can occur in a matter of hours. Unfortunately, the opposite is true when prices fall.
Trading short or long
Unlike futures contracts, CFDs have no expiry date, so as long as traders have sufficient margin in their accounts, they can hold on to their CFD and play the long game. However, the trader's account will be subject to dividend and interest payments if a selling contract is in place - predicting that the share price will actually fall. Starting from a buying position - or trading long - will deliver interest payments and dividends if the share price rises. It is this opportunity to make money regardless of the overall health of the markets that proves so popular with investors.