5. What is Contract for Difference (CFD)?
What is CFD?
CFD, or Contract for Difference, is a relatively new type of derivative in the financial markets, where investors can start trading after paying a small amount of margin to banks or brokers according to the agreement. Most CFD transactions cover a variety of financial assets and commodities, including forex, precious metals, energy, stocks, indexes and cryptocurrencies. In theory, investors can trade all “underlying assets” through the concept of CFD.
Origin and operation of CFD trading
In the international financial market, the lot size of many transactions is quite large (thousands of USD), that is, it requires a certain amount of initial capital. As a result, these trades are out of reach for the average investors (so-called retail investors). To facilitate these small investors’ access to financial markets, some brokers, banks and liquidity providers have developed “contracts” that offer flexibility and trade-in units as small as one-tenth or even one-thousandth of an ordinary standard transaction.
The role of brokers or dealers is to provide a platform for small investors to join the market, bring together small trades and match them with international financial markets. In other words, brokers or dealers, just acting like banks, provide liquidity to the retail market, making trading popularized.
It should be noted that this trading model does not involve the actual ownership of underlying assets (no physical settlement), that is, it only uses the price difference between the contract opening price and the contract closing price for profit & loss (cash) settlement.
Characteristics of CFD
CFD mostly trades on margin, which is called leverage trading. Therefore, the initial cost of investors’ investment is relatively low, and they can use fewer funds to hold larger positions, which can increase trading flexibility and the rate of return.
Related article: “Why use leverage?“
Long and short position allowed:
You can trade a variety of financial products via CFD and can go long or go short. Therefore, it is convenient and flexible for investors to diversify their portfolios and hedge specific positions in the financial market.
Long trading time:
Most of the platforms providing CFDs also provide 24-hour trading and generally have no contract expiration date, providing investors with potentially better entry or exit prices.
No physical settlement:
CFD does not need investors to actually hold the assets, but only trades against the price of those underlying. The profit & loss comes from the price difference, and the investor will not make a physical settlement with the counterparties.
CFD transactions usually charge rollover fees (so-called swap, overnight interest) when investors hold positions overnight. If investors hold positions for a long time, such costs may lower their net profit.
In conclusion, CFD allows investors to invest in a diversified way using stocks, forex, indexes and commodities. This gives investors options without needing large amounts of capital. Investing in these options, avoiding higher fees and additional costs associated with other investments, such as taxes.
This advantage makes the CFD trading model popular among small investors today.