CFD Trading: What are Contracts for Difference?

If looking for a leverage form of investment opportunity which goes beyond the boundaries of exchange traded derivatives, one option is to consider the use of over the counter derivatives trading in the form of CFDs or contracts for difference.

Contracts for Difference: What are CFDs?

Contracts for difference are a non-exchange traded derivative occupying a position midway between futures trading and spread betting. The CFD allows an individual to gain a leverage exposure to fluctuations in the value of a wide range of underlying assets. In addition, the ability to take a long and a short position allows an investor to potentially benefit from both rises and fall in the value of an underlying asset.

As a non-exchange traded derivative, CFDs are traded between private investors and an approved broker dealing CFDs. Whilst CFDs are a non-exchange traded derivative, the responsibility for regulation in the UK still falls under the umbrella of the Financial Services Authority (FSA). Make sure to do your own research or visit a site that has done that all ready to make sure that you join the best CFD trading platforms on the net today. They all have benefits and disadvantages so make sure to pick the one that fits your investment strategy.

How do Contracts for Difference Work?

From a mechanical perspective, the investor can choose to buy or sell a CFD at an agreed price depending upon whether a rise or fall in the value of an underlying asset is expected. If a rise in the value of the underlying asset is expected, then a CFD will be bought giving the investor a long position. If the value of the underlying asset is expected to fall, then a CFD will be sold, thus giving the investor a short position.

  • Closing a Long Position – When an investor wishes to close a long position they must then sell the contract, if the value of the underlying asset has risen then the contract will be worth more than the investor paid, as such a profit is made. Where the underlying asset has fallen, then a loss is made as the contract is sold at a lower value than the purchase price.
  • Closing a Short Position – When an investor wishes to close a short position they must effectively buy a contract to bring the position back to zero. Where the value of the underlying asset has fallen a profit will be made as a contract is purchased at a price below agreed rate. Conversely if the underlying value of the asset has risen, then a loss will be made as the investor is forced to buy a contract at a higher rate then that of the settlement.
  • Calculating the Profit of a CFD Trade – In order to calculate the profit or loss of a CFD trade one simply multiplies the movement in the value of the underlying asset by multiple of the contract. For instance, if a CFD of 1,000 shares at £1 each is entered into and the share price rises to £2, then the profit or loss is equal to £1,000 or 1,000 shares multiplied by the movement of £1 each. Whether this represents a profit or loss will be dependent in whether a short or long position was taken.

CFD Trading: The Leverage Concept

One of the key differences between CFD trading and the direct buying and selling of stocks and shares or other underlying assets is that a leveraged exposure is gained. In the ordinary trading of stocks and shares or other assets, one must pay in full for the asset. However, in CFD trading a broker will only require small percentage of the value of the underlying assets to be placed in a trading account.

For example if one wished to gain an exposure to 1,000 shares trading at £1 each by means of a standard trade, then the investor would be required to purchase the shares at a value of £1,000 excluding fees. However, if a broker requires only a 10% deposit to be placed on the value of a CFD trade then only £100 would have to be placed to gain the same exposure.

Another way of viewing such a leveraged position is to consider that the CFD trade in the context of the above scenario would allow an exposure to 10,000 shares in comparison to an exposure just 1,000 shares, if the stocks and shares had been traded directly.

In summary, entering into CFD trading arrangements allows an individual investor the opportunity to experience far greater gains than if the underlying assets and securities were traded in directly. However, the downside of CFD trading is that the derivative carries a much higher degree of risk than the direct trading of an underlying assets or security.

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