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What are CFDs (Contract For Difference)?

A contract for difference (or CFD) is a contract between two parties, typically described as "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 instead to the seller.) For example, when applied to equities, such a contract is an equity derivative that allows investors to speculate on share price movements, without the need for ownership of the underlying shares

Contracts for difference allow investors to take long or short positions, and unlike futures contracts have no fixed expiry date, standardised contract or contract size. Trades are conducted on a leveraged basis with margins typically ranging from 1% to 30% of the notional value for CFDs on leading equities.

The contracts are subject to a daily financing charge, usually applied at a previously agreed rate linked to LIBOR or some other interest rate benchmark e.g. Reserve bank Rate in Australia. The parties to a CFD pay to finance long positions and may receive funding on short positions in lieu of deferring sale proceeds. The contracts are settled for the cash differential between the price of the opening and closing trades.

Traditionally, CFDs are subject to a commission charge on equities that is a percentage of the size of the position for each trade. Alternatively, an investor can opt to trade with a market maker, foregoing commissions at the expense of a larger bid/offer spread on the instrument.

Investors in CFDs are required to maintain a certain amount of margin as defined by the brokerage or market maker (usually ranging from 1% to 30%). One advantage to investors of not having to put up as collateral the full notional value of the CFD is that a given quantity of capital can control a larger position, amplifying the potential for profit or loss. On the other hand, a leveraged position in a volatile CFD can expose the buyer to a margin call in a downturn, which often leads to losing a substantial part of the assets.

As with many leveraged products, maximum exposure is not limited to the initial investment; it is possible to lose more than one put in. These risks are typically mitigated through use of stop orders and other risk reduction strategies (for the most risk averse, guaranteed stop loss orders are available at the cost of an additional one-point premium on the position and/or an inflated commission on the trade).