Contracts for Difference Explained

Posted by jenni on April 28th, 2017

What is a CFD?

A CFD (Contract for Difference) is a financial derivative  that allows traders to profit, or incur losses, relative to the price movements of an underlying financial security. The Contract for Difference is an arrangement for one party to pay the difference in value from when the contract was opened to when it was closed. CFDs are offered on 1,000s of markets, including commodities, currencies, indices and shares.

History of CFDs

CFDs are a relatively new financial product. Devised in London in the 1990s, they were first used by hedge funds looking to short sell and place larger trades than they could on the underlying market. CFDs offered the perfect opportunity to trade with leverageand go short on 1,000s of financial markets whilst avoiding UK Stamp Duty.

The tech boom of the late 1990s provided a wealth of new markets ideally suited to CFDs, and CFD trading has now spread to other major financial centres. Approximately a third of the total volume traded on the London Stock Exchange is CFD related.

How does CFD trading work?

CFD trading enables speculation on market movements without owning the underlying asset. Contracts are bought instead of shares, with an agreement to swap the difference in value at the closing of the contract.

Example CFD trade:

A short trade is opened in expectation that the price of the UK100 index is going to fall. For instance, the UK 100 is currently trading with a bid-offer spread of 6,300.1 – 6,300.9. A trader decides to ‘go short’ 10 CFDs (with a pip location of 0.1 and a value per pip of £1) with a total value of £630,010 ((10/0.1) x 6,300.1).

As anticipated by the trader the market falls and at a quote of 6,290.4 – 6,291.2 the trader decides to close the contract at a price of 6,291.2. The difference between the opening value of the trade (£630,010) and the closing level of the trade (£629,120) is £890.

Opening Leg:  £6,300.1

Closing Leg: £6,291.2

Difference:  £8.90

No. of Contracts: 10 (Pip location 0.1, Pip value GBP 1)

Profit on Trade: £8.90 x (10 / 0.1) = £890

A long trade is opened in anticipation of the market rising. For example, a trader believes that the value of the US Tech 100 is going to appreciate. The index is currently quoted at a bid-offer spread of 4,300.2-4,300.6, so the trader goes long with 10 CFDs entering a contract (with a pip location of 0.1 and a value per pip of ) with a total notional value of 0,060 (10/0.1 x ,300.6).

Against the trader’s expectations, the US Tech 100 falls and at a price of 4,280.2 – 4,280.6 the trader closes the trade, selling 10 CFDs at 4,280.2. The difference between the opening value of the trade (0,060) and the closing level of the trade (8,020) is ,040.

Opening Leg: ,300.6

Closing Leg: ,280.2

Difference: .40

No. of Contracts: 10 (Pip location 0.1, Pip value USD 1)

Loss on Trade: .40 x (10 / 0.1) = ,040

Margin trading

A key difference between a CFD and traditional forms of trading is that it is a leveraged product. This means that only a small percentage of the total exposure to a trade needs to be deposited up-front. With Axis forex online send money in 100+ currencies at any bank account in the world. Buy forex card for hassle-free & cashless travel. 24X7 availability!

Source : https://www.corespreads.com/knowledge-base/cfds-explained/