CFD contracts: what are they?

2024 Author: Howard Calhoun | [email protected]. Last modified: 2024-01-07 20:55

CFD contracts are an agreement on the difference in the value of the contract after its completion between the price of its opening and closing, with the participation of two parties to the exchange.

CFD concept

When translating this abbreviation from English, you can get that CFD is a "contract for difference". Its history spans over two decades. But it has 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, stocks, stock indices, goods can act. Which of the parties of this contract will receive a profit, and which - a loss, depends on the opening and closing prices.

Explanation

Let's consider a CFD contract. This will be an explanatory example. Suppose that the seller and the buyer agree that one of them will pay the difference in price between the one that exists ontoday and the one that will be installed on this asset, after a certain time, which is specified in this contract.

Income can be received by the buyer if the price of the asset rises over a 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 the margin, which is the difference between the initial and final prices. Otherwise, the buyer pays the difference. With this contract, you can open short and long positions.

As you can see from the above explanation, the considered type of transaction 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 many times exceed the security deposit. Thus, in its essence, this contract provides an opportunity to purchase on credit. As with any other similar loan, you need to pay interest on your trading account.

This tool made it possible to attract traders to the market with small capitalization, but with the ability to make money out of thin air, with certain experience and knowledge in this business.

Historical perspective

The contract in question appeared about two decades ago in London, thanks to Smith New Court. His appearance was due to two reasons:

• there were laws heavily limiting leverage;
• a tax was introduced on securities trading.

Since the securities do not actually come into possession of the parties, the above payment is not payable, and the margin leverage for these transactions can be any.

At the end of the last century, GNI offered its clients the use of share CFDs traded on the London Stock Exchange through its trading platform. Over time, the benefits of the deals in question have become apparent to other players as well. Other European financial houses have followed this path.

Today, this type of transactions in the British market is about 25% of the turnover of shares.

Thus, CFD contracts are transactions that allowed us to cancel the limit on margin leverage, as well as avoid paying tax on trading operations with securities.

Positive and negative aspects of the objects under consideration

CFD trading assumes that you do not have a real asset, while you can potentially receive income from the price dynamics for it. These types of contracts allow you to hedge risks, which involves opening opposite transactions in order to insure profits from price movements.

The margin for opening a trade is quite low and does not exceed 10% of the contract price.

No need to wait for the confirmation of opened orders on the exchange.

Investments are diversified, there is no need to open accounts in other firms in case of trading in different markets.

Trading can be carried out at the same prices supported by other speculators.

Work with the contracts in question can be carried out worldwide. The main condition is access to the global Internet network.

The disadvantage of these contracts is the same one that is typical for the securities market as a whole - speculation. With CFDs, there is a need to pay the spread on a regular basis, both when opening and closing transactions. The trader cannot receive any dividends on the asset since he is not the owner of the asset.

The latter's small account carries significant risks for him.

The difference between CFDs and stocks

An investor working with a CFD cannot take part in voting, attend shareholder meetings, as he does not actually own these assets.

CFDs are purchased and sold in the trading system of the same broker.

This contract is traded with leverage, so if the position is rolled over to another day, the investor pays an additional brokerage commission for using his borrowed funds.

A positive percentage difference is credited to the trader's account with a short CFD position, but the latter require him to pay dividends, while they are accrued to him with long positions.

How a CFD contract works

During the operation of the transaction, a certain share of the trader's deposit remains collateral, which will cover possible losses. This amount is on the trader's account, its dynamics depends on the price of the asset.

The margin for stock trading is many times higher than that for a CFD contract.

Opening a position is accompanied by a loss on the trader's account, which is equal to the current spread in the market. If the price starts to decrease, this will lead to a directly proportional dynamics in terms of free cash in the account, which will ultimately require either depositing additional funds in order to maintain the required margin level, or closing the position. If neither condition is met, then the last action occurs automatically.

Comparison of CFD contracts and Forex instruments

Conclusion of the considered transactions in the foreign exchange market is just beginning to gain momentum.

Let's compare CFD contracts on Forex with instruments existing on this exchange.

Similarities between them:

• trading is carried out via the Internet using trading terminals;
• possible to diversify portfolios to insure against potential losses;
• aimed at speculative profit;
• no need to pay taxes when withdrawing money from a trading account;
• there is leverage that you need to pay for using;
• between purchase pricesand selling there is a spread;
• exits to international markets are provided by the same brokerage companies;
• application of fundamental analysis is relevant.

Differences between CFD contracts and Forex:

• trading in the contracts in question is possible only during the American session, while Forex works around the clock on weekdays;
• On Forex there is a game on currency pairs, and on CFD contracts it is carried out on various assets and goods;
• the maximum level of leverage on the currency exchange is higher compared to the considered types of transactions;
• The risk in CFDs is significantly lower than in Forex.

Trading Strategies

As we have already found out, a CFD is an agreement between a seller and a buyer that one of them will receive a profit and the other a loss.

The easiest strategies to generate income are as follows:

• short - a trader opens a deal to sell an asset at a specific price; in this case, he will receive income when the price of this instrument decreases 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 increases some time after the opening of trading.

These two strategies do not have an expiration datetransactions, but it is necessary to carry out a monthly transfer while observing the principles of money management.

There are other strategies for CFD contracts:

• pair trading - the simultaneous purchase of CFDs of one asset and the sale of another. Instruments are selected close in nature of movement and psychology. The implementation of this strategy is designed to offset the loss on one of the assets by making a profit on the other;
• application of a calendar spread - deals are made for the same asset in different time periods;
• hedging - opening a position that has the opposite direction in order to cover the transaction with an opposite position or close part of the first one. They are carried out at moments of increased risk for the trader.

CFD contracts in Russia

The activity of brokers working with CFD contracts in our country is not regulated today. We only allow currency pairs traded on Forex for trading. Some dealers on this exchange want to request that CFDs be allowed on the list.

Thus, these contracts are limited in our country, however, if they are concluded with Forex dealers, the client can rely on the protection of the state.

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.

In closing

SoThus, CFD contracts are a tool of interest for both beginners and experienced traders. With its help, you can start earning with the dynamics of the prices 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 terminates at the request of one of the parties that has such a right.