What are CFDs?
A contract for Difference or CFD is an agreement between two parties to pay the difference in price of the contract between the time it was opened and the time it was closed.
A CFD is a derivative product – this means that it mirrors or reflects the price of the financial instrument or product it is based on. CFDs are not traded on an exchange but a classed as Over-the-Counter (OTC) products.
Because a CFD is a derivative you don’t own the underlying product, you just have the opportunity to benefit (or lose) from the price movements by providing an initial margin. With CFDs margins can be as low as 5 or 10%. This means that your leverage is very high which has risks which we will explore later. CFDs are available over shares, indices or baskets of securities, commodities or foreign exchange.
As a party to a CFD you can be paid an amount of money (profit) or be required to pay an amount of money (loss) arising from the change in price or value of the underlying product of the CFD.
Let’s look at a very simple example to better understand how CFDs work:
If you had $10,000 in cash and wanted to buy $10000 worth of XYZ shares with the expectation that they will rise in price, you could either
- use all your own money and buy a parcel of XYZ shares directly
- use $1000 of your money (initial margin) to purchase $10,000 worth of XYZ CFDs
Let’s look at the outcomes for both options if the share price rises and if it falls:
Direct Share | CFD Purchase | |
Purchase | 10,000 shares @$1 Cost – $10000 |
10,000 CFDs @$1 on 10% Margin Cost – $1000 |
Sell if rises by 10% | Value – $11000 Profit – $1000 Return – 10% |
Value – $11000 Profit – $1000 Return – 100% (based on initial margin cost) |
Sell if falls by 10% | Value – $9000 Loss – $1000 Return – 10% |
Value – $9000 Loss – $1000 Return – 100% |
You can see from this example that for both options the $ profit and loss outcomes are the same, however, the percentage returns (both positive and negative) have been magnified.
Let’s next look at why you may want to use CFDs.