What are CFDs?

A contract for difference (CFD) is an unlisted instrument that is an agreement between a buyer and a seller.

The two parties make a contract that the seller will pay the buyer the difference in value of a particular instrument on a daily basis for the period between when the contract is opened and when it is closed.

The buyer will in return pay the seller the difference in price if its value decreases.

The difference is determined by referring to an underlying instrument.

CFD contracts provide a means for an investor to hedge against risk exposure or to speculate when an exchange rate change appears imminent. CFDs enable investors to gear (leverage) their investment, while avoiding many of the costs and hassles of trading in the underlying instrument.

Shorting

One of the main advantages of trading CFD’s is having the ability to “Short” the contract or take advantage of the underlying price of the asset falling. Instead of buying the contract from the broker, the broker buys the contract from you. So you are selling “Short” the underlying asset to the broker who will be implicitly Long.

If the price of the asset then falls you will make money and the “Difference” will be paid into your trading account on a “Marked to Market” basis (based on the closing price of the underlying asset) each day. If the underlying asset goes up, you will lose money and the broker takes the “Difference” out of your trading account each day.

Trading short can be more dangerous than trading long. If you buy something (anything), the most you can lose is 100% of the notional value of the position because it means the underlying asset has gone to Zero. If you trade short, theoretically you can lose an infinite amount of money. The asset could go to infinity! Be careful when shorting on CFD or when utilizing any “vehicle” that allows you to short. You can expect to learn a whole lot more than this on our Educational Trading Programme. To be redirected to this area of the website click HERE.

In terms of dividends, when you are short a CFD contract, you will also be what is termed “Short the Dividend” – When the company pays its dividend on the ex Dividend Date, The price of the contract will be changed (in your live trading account), to reflect the amount of the Dividend in favour of the Broker. You will be paying out the amount of the Dividend.

Why trade CFDs?

Features and benefits of trading CFDs, such as:

  • Gearing which amplifies the movement of the CFD relative to the underlying share
  • Earn dividends
  • Product simplicity (over-the-counter product)
  • Short trading
  • Pairs trading
  • CFD’s don’t expire