CFD’s or contracts for difference are derivative products that are traded very similarly to options and futures for those of you who are familiar with those. The one main difference is that there is no contract dictating the end date of the trade. In other words, you can hold the trade as long as you want based on how the position is playing out. Let’s now explore a little more on the basics of these financial instruments and then look at an example trade to illustrate how they work.
What is a CFD?
A contract for difference is the difference between where a trade is entered and exited. This instrument will mirror the underlying assets price movements but you’ll never actually own the asset itself. It’s essentially a contract between a client and a broker. As with any investment, CFD’s come with advantages and disadvantages which we will go into later.
How CFDs Works
CFD’s give you more leverage than traders who trade with traditional margin trading. While a margin account with a traditional broker will require you to set aside at least 50% of the trade’s value, a contract for difference only requires you to set aside 5%. Just like with stocks, you can enter both long and short positions with CFD’s. As the value of the underlying stock or other asset increases or decreases, your CFD’s value will also follow suit.
CFD’s require less capital reserve and you can find the margin requirement for such accounts to fluctuate between 2 and 20% percent. This ability allows you to make more money than with traditional margin trading. In addition, you can profit from stocks whose share price is too high for you to purchase with the funds you have; shares of Google or Berkshire Hathaway come to mind. You can actually buy interests in these great companies with only a few hundred dollars. In addition, many brokers make it easy to open an account with only $1,000 or $2,000 minimum deposits.
Increased leverage is a double edged sword. As gains can increase greatly, losses can also mount quickly and to the point where you lose more than your initial margin requirement. It’s not impossible to realize greater than 100% losses when trading CFD’s. You will also have to pay each time you enter and exit the trade and daily interest on the margin you borrowed. The daily interest charge can especially eat into your profits on a trade that is stagnant and held for many days. The CFD industry is not highly regulated so it does have a little more risk than with other traditional investments. Because of this, you must do extra due diligence when researching and selecting a broker to use for your CFD trading. Reading more news, articles and guides about CFD trading might help you get started.
Buy 100 shares of GOOG5% Margin Requirement
Commission of .1%
Daily Interest of $3.25 for 4 days
Sell 100 Shares of GOOG
Commission of .1%
100 x $570 = $57,000
$57,000 x .05 = $2,850
$57,000 x .001 = $57
4 x $3.25 = $13 (held for 4 days)
100 x $580 = $58,000
$58,000 x .001 = $58
$1000 (58,000-57,000) – $128 (57+58+13) = $872
CFD’s offer a great way to use leverage and make more money than you could if you simply owned shares in the company. They’re also good tools to profits from stock market stocks with high share prices that you can’t own based on your available cash. These instruments have very low margin requirements but can also cause you to take larger losses because of your ability to use high amounts of leverage.