CFD contracts are a contract for the difference in the value of a contract after its completion between the price of its opening and closing, with the participation of two exchange parties.
CFD Concept
When translating this abbreviation from English, you can get that CFD is a “contract for difference”. Its history goes back more than two decades. But he gained the most popularity recently.
This type of contract guarantees that the difference between the opening and closing prices will be settled between the seller and the buyer.
As a purchase may be stocks, stock indices, goods. Which of the parties to this contract will receive income, and which - loss, depends on the opening and closing prices.
Explanation
Consider a CFD contract. This will be an illustrative example. Suppose that the seller and the buyer have agreed that one of them will pay the difference in price between the one that exists at the moment and the one that will be installed on this asset, after a certain time, which is specified in this contract.
The buyer can receive income if the price of the asset rises over the specified period of time. In this case, the seller pays the buyer the price of the goods at the time of the conclusion of the contract, as well as a margin, which is the difference between the initial and final costs. In the opposite case, the buyer pays the difference. With this contract, you can open short and long positions.
As can be seen from the above explanation, the type of transaction under consideration is similar to those called futures. But at the same time, CFD-contracts do not have a fixed date for the completion of the transaction.
When using the objects in question, you can get high profitability due to the fact that leverage is provided. The latter makes it possible to conclude transactions for such amounts that are many times higher than the security deposit. Thus, in essence, this contract provides an opportunity to purchase on credit. As with any other similar loan, you need to pay interest on it from the trading account.
This tool made it possible to attract people with small capitalization, but with the ability to make money out of thin air, who have certain experience and knowledge in the market, to traders.
Historical perspective
The contract in question appeared about two decades ago in London, thanks to Smith New Court. Its appearance was due to two reasons:
Since the securities do not actually come into the possession of the parties, the payment mentioned above is not payable, and the margin leverage for these transactions can be any.
At the end of the last century, GNI offered its customers to use CFDs for stocks that were traded on the London Stock Exchange through its trading platform. Over time, the benefits of the transactions in question became apparent to other players. Other European financial houses went along this path.
To date, this type of transaction in the UK market is about 25% of the turnover of shares.
Thus, CFD-contracts are transactions that allowed to abolish the margin leverage limit, as well as to avoid paying taxes on trading with securities.
Positive and negative sides of the objects in question
Trading CFDs implies that you do not have a real asset, and you can potentially receive income from price dynamics. These types of contracts make it possible to hedge risks that involve opening opposite transactions in order to insure profit from price dynamics.
The margin for opening a transaction is quite low and amounts to no more than 10% of the contract price.
No need to wait for the certification of open orders on the exchange.
Investments are diversified, there is no need to open accounts in other companies in case of trading in various markets.
Trading can be carried out at the same prices that are supported by other speculators.
Work with the considered contracts can be carried out worldwide. The main condition is that you need access to the global Internet.
The disadvantage of these contracts is the same, which is typical for the securities market as a whole - speculation. With CFDs, there is a need to pay the spread in a constant mode, both at the opening and closing of transactions. The trader cannot receive any dividends on the asset, since he is not its owner.
A small account of the latter carries significant risks for him.
Difference between CFDs and stocks
An investor working with a CFD price difference contract cannot vote, attend meetings of shareholders, because he actually does not own these assets.
The acquisition and implementation of CFDs is carried out in the trading system of the same broker.
Trading this contract is carried out with leverage, therefore, in case of transferring the position to another day, the investor pays an additional brokerage fee for using his borrowed funds.
A positive percentage difference is credited to the trader's account for a short CFD position, but the latter require him to pay dividends, while for long ones they are accrued to him.
How the CFD contract works
During the transaction, a certain portion of the trader’s deposit remains collateral, which will cover possible losses. This amount is on the trading account, its dynamics depends on the price of the asset.
The margin on stock trading is many times higher than that of a CFD contract.
Opening a position is accompanied by a loss in the trading account, which amounts to the current spread in the market. If the price starts to decrease, this will entail a directly proportional dynamics in relation to free cash on the account, which ultimately requires either additional funds to be added there in order to maintain the necessary marginal level, or to close the position. If neither condition is met, then the last action occurs automatically.
Comparison of CFDs and Forex Instruments
The conclusion of the transactions in the foreign exchange market is only beginning to gain momentum.
Let's compare CFD contracts on Forex with instruments existing on this exchange.
The similarities between them:
trade is carried out through the Internet using trading terminals;
it is possible to diversify portfolios for insurance against potential losses;
aimed at obtaining speculative profit;
No need to pay taxes when withdrawing money from a trading account;
there is a leverage for which you have to pay;
there is a spread between the purchase and sale prices;
access to international markets is provided by the same brokerage companies;
actual application of fundamental analysis.
Differences of CFD-contracts from "Forex":
trading under contracts is possible only during the American session, while Forex is working around the clock on weekdays;
Forex is a game in currency pairs, and for CFD-contracts it is carried out for various assets and goods;
the maximum level of leverage on the currency exchange is higher compared to the types of transactions under consideration;
CFD risk is significantly lower compared to Forex.
Trading strategies
As we have already found out, the CFD difference contract is a contract between the seller and the buyer regarding the receipt of profit by one of them and loss by the other.
The simplest strategies for generating income are as follows:
short - a trader opens a transaction for the sale of an asset at a specific price; in this case, he will receive income by reducing the price of this instrument in a certain time period in the future;
long - a trader opens a deal to buy an asset; it will remain in profit if the price of the asset rises some time after the opening of trading.
These two strategies do not imply a deal expiration date, but it is necessary to carry out a monthly transfer subject to the principles of money management.
There are other CFD contract strategies:
pair trading - simultaneous purchase of CFDs of one asset and sale of another. Tools are selected close in nature to movement and psychology. The implementation of this strategy is designed to level the loss on one of the assets by making a profit on the other;
application of the calendar spread - deals are concluded for the same asset at different time periods;
hedging - the opening of a position having the opposite direction in order to block the transaction with a counter position or to close part one. They are carried out at moments of increased risk for the trader.
CFDs in Russia
The activities of brokers working with CFD-contracts in our country today are not regulated. We only allow currency pairs traded on Forex for trading. Some dealers of this exchange want to ask for inclusion of CFDs in the list of allowed.
Thus, these contracts have restrictions in our country, however, if they are concluded with Forex dealers, the client can rely on state protection.
Some traders make it possible to earn using these transactions on such underlying assets as oil, gold, silver, futures on stock exchanges, shares on the New York Stock Exchange.
Finally
Thus, CFD contracts are a tool of interest to both beginners and experienced traders. With it, you can start making money with the price dynamics of various assets with a small starting capital and the absence of the right to actually own them. The validity period at the conclusion of such a contract is not specified, it expires upon the application of one of the parties that has such a right.