A contract for difference, or CFD, is a type of financial derivative that is used by traders to take advantage of the constant changes occurring in the financial market.
It’s a derivative because the value of the contract comes from a mix of different things like commodities, stocks, bonds, interest rates and even currencies.
A CFD is essentially an agreement (contract) between two parties, the buyer and the seller. The exchange is designed to speculate on where the market will be when the contract ends.
The CFD will stipulate that when the contract ends, the seller will pay the buyer the difference between the current value of an asset and its price when the contract started.
If the difference is negative, then the buyer has to pay the seller instead.
So, on one hand, you’ve got a seller hoping that the buyer will pay the difference for an asset that is now worth less than when the contract commenced. On the other, the buyer is hoping that the asset is worth more.
Essentially, as a CFD trader you are betting on the future value of a mixed group of financial assets, with profits and losses being calculated in real time.
No matter which way you look at them, CFDs are at the riskier end of investment options available in Australia.
Where are CFDs used?
CFDs are permitted in Australia and many other countries but are prohibited in America as they are Over The Counter (OTC) trades. This means that the speculation, contracts and resulting payments are performed outside the stock exchange.
Originally, CFDs were used by hedge funds and large institutional traders to hedge on exposure to shares on the London Stock Exchange. Hedging in this way is cost effective for those involved because the physical stocks were not exchanged, just the difference in the value between the start and end of the contract. This means tax payments were avoided.
Regulations have been implemented in most countries that permit CFD trading to ensure they are not used for insider trading.
How do CFDs work?
There are not standard contract terms; each CFD provider issues terms to individual traders. But, there are some elements that tend to be common across all CFDs.
Making an opening trade with the provider to create what is known as the ‘position’ starts the contract. There is no expiry date so the position is closed only when the second, and reverse trade is done.
This is when the difference is calculated between the opening trade and the closing trade price. The CFD provider will charge the trader for the trading that opens and closes the position. There may be other fees as well, such as commission, overnight financing and management fees.
The CFD provider can also make a bid-offer at any time. This means that the provider can offer to buy out the contract at a price that is different to the current market value but minimises losses.
While there is no expiry set to any contract, any positions that are left open overnight undergo an assessment at the close of trading. Any profit or loss based on the day’s trading is calculated. This amount is debited, or credited, to the trader, less any fees incurred. The position then carries forward to the next day’s trading to continue the CFD.
There are limits set as CFDs are traded on margin. The profit and loss on the contract is calculated in real time. If the amount of money deposited with a CFD provider drops below a minimum level, a margin call can be made on the trader.
Who are CFD traders?
There are around 44 CFD providers in Australia; including CMC Markets, GFT, IG Markets, City Index, Capital CFDs and Saxo.
To trade CFDs, individuals need have an account with one of the ASX CFD nominated brokers: Commsec, Morrison Securities, Sentinel Group and Interactive Brokers.
Research by Investment Trends estimates that there were 41,000 Australians classified as active CFD traders in 2012. In 2012, the Australian Securities and Investment Commission (ASIC) estimated there was about $400 million at stake in CFDs.
The same research from Investment Trends found that about 40 per cent of traders are winners, 44 per cent are losers and 16 per cent broke even in 2010, when there was around $350 million at stake.
However, some CFD providers, of which there are 44 in Australia, believe the loss/win ratio to be much higher. Some state that it’s as high as 70/30, mainly due to novice investors who lack experience, take ill-judged risks and often do not understand the complexities of CFD trading.
CFDs are complex, high-risk financial investments. If you are considering investing in CFDs ensure you get educated and understand the potential risk, rather than focusing solely on the potential for profit.
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