Contract of Difference (CFD) is a popular equity derivative that combines the features of many other financial instruments like stocks, options, futures and forex currency pairs. It is basically a contract to pay or receive the ‘difference’ in enter and exit prices (of underlying instrument) of a trade. When at selling the underlying instrument price rises against the same when contract was bought, the buyer profits; and in reverse scenario suffer loss. The underlying instrument may be stock, market indices, treasuries, currency pairs, commodities, and more. There are no actual ownership of underlying asset.
CFDs are popular trading instruments in many countries across the world. But US traders won’t find them in their investment options because of the Securities Exchange Commission (SEC) regulation on Over-The-Counter (OTC) traded instruments. Generally, CFD trading has very relaxed regulations and there are no standard contract terms. Most CFDs have simple and easy-to-understand terms.
As a financial instrument CFDs have great similarity to options in exposure to underlying instrument. But unlike options, CFDs do not have any expiry date or options premium. The position can be closed when a reverse trade is made. CFDs are traded just like forex currency pairs and often on forex trading software. Like forex, there are no trading commissions, instead the broker profit from the ask/bid spread difference.
Contracts of Difference trading offer a number of advantages over other instrument trading, especially over equity trading.
1. High leverage: CFD trading involves high leverage and relaxed margin requirements than stock trading. The typical stock trading margin requirement can be 50% or $500 for trading $1000 positions, but CFD traders can trade on margin requirement as low as 2% – typically ranges from 2% to 20% depending on the liquidity of underlying instrument. That means a trader can trade $1000 worth contracts with just $20 capital investment.
2. Availability of a variety of underlying instruments: CFDs are available on a variety of financial products that are typically not available in options trading. These include stocks, stock indices, most types of commodities, currency pairs, treasuries, and even market sectors.
3. Global market access: CFD trades are often not bounded with any specific exchange of country. Like forex, traders can trade products on most world markets from one single trading platform. Trades can be executed when the market is open on broker platform.
4. No trading commission or brokerage fee: CFD trades do not involve any broker commission. The broker profits from fixed spreads. More over traders can get execution of all types of order types and trading privileges which are available to stock and forex traders.
5. No day trading requirements or shorting rules: CFD trades include much relaxed rules. Traders can go long or short any time they want. Traders can day trade whenever they want. As there is no ownership of underlying instruments there are no burrowing fee or shorting costs when going short.
Leverage is always a double-edged sword; it can magnify the profit but also do the same for losses. High leverage and low capital investments can often results in margin calls if the underlying instrument price drops. The spread difference on entries and exists can reduce profits when trading for small price changes. Also the industry is not much regulated yet, so finding the right and reputed brokerage firm for trading becomes much more important.