Is a speculative financial arrangement in the form of a futures contract, whereby differences (financial) in settlement are made through financial payments, rather than the actual delivery of physical goods or securities. This is generally an easier method of settlement because losses and gains are paid in currency/money to the trader/investor or broker. CFDs provide investors with the all the benefits and risks of speculation in a security/currency, without actually taking ownership of it. The price is derived from the price of the underlying product/instrument that is traded in the markets.
In finance, a “contract for difference” (CFD) is a contract between the broker/Market Maker and trader/investor, as “buyer” and “seller”, the buyer will pay to the seller the difference between the current value of an asset and its value at completion of contract expiry. (If the difference is negative, then the seller pays instead to the buyer.) CFDs are speculative financial derivatives that allow investors to take advantage of prices moving up (long executions) or prices moving down (short executions) on underlying financial instruments and are used to speculate in these market places.
CFDs allow for smaller “margin” requirements for larger contract values, unlike fiscal share trading where “full value” would be paid for the number of shares purchased. To sell the fiscal shares, a buyer must be found which may be difficult, for example “bad news is released” the price drops and no liquidity/buyer can be found.
CFDs were originally developed in the early 1990s in London. Based on equity swaps, they had the additional benefit of being traded on margin and being exempt of stamp duty, a UK tax.
Around 2001 a number of the CFD providers realised that CFDs have the same economic effect as financial spread betting except that, the tax regime was different, making it in effect “tax free” for investors, spread betting relying on a country specific tax advantage has remained primarily in UK and Ireland.
CFDs are traded between individual traders and CFD providers. There are no standard contract terms for CFDs, and each CFD provider can specify their own, but they tend to have a number of things in common.
The CFD is started by opening trade on a particular instrument with the MM/Broker. This creates a “position” in that particular instrument. There is no expiry date so the position is closed when a second reverse trade is done (close) or a “Take Profit/Stop Loss” is hit. At that point the difference between the opening investment and the closing investment is paid as either profit or loss. The MM/Broker generally makes his commission on the “Bid/Ask spread” a very small percentage of the contract.
Even though the CFD does not expire, any positions that are left open overnight will be “rolled over”. This typically means that any profit and loss is realised and credited or debited to the client account and any financing charges are calculated. The position then carries forward to the next day. Conventionally this process is done at 10pm GMT and uses the overnight LIBOR rates.
CFDs are traded on margin, and the trader must maintain the minimum margin level to cover the position. A typical feature of CFD trading is that profit and loss and margin requirement is calculated constantly in real time and shown to the trader on screen. If the amount of money deposited with CFD broker drops below minimum margin level, margin calls can be made. Traders may need to cover these margins quickly otherwise the CFD provider may liquidate their positions.