What is a Contract for Difference?
In the world of finance, CFDs, or Contracts for Difference, are a form of contract that links a buyer and seller. The buyer can make profits equalling the difference between the asset price at the moment of subscription and the price at the moment of reselling.
When the difference between the starting point and closing point is negative, it is the seller that gains the amount obtained, and the buyer is the loser.
CFDs are some of the financial derivative instruments available that enable trading on the rise and on the fall of prices by speculating on the rate movements of an underlying asset. This asset may be in various forms such as currencies, shares, indices or even commodities.
The operation of contracts for difference:
As you have probably understood, a CFD is a contract completed between two investors that exchange the amount of the difference between the opening rate and the closing rate of a given asset. Previously reserved for investment professionals, CFDs have been simplified and made accessible to all by the online brokers that enable all investors to use them without requiring any great knowledge of trading.
CFDs generally offer a leverage effect that can go up to 1:20 according to the asset traded. In fact, the most volatile assets have a lower leverage effect than the less volatile assets due to potential profits, but also the risk level incurred. Due to this leverage effect you can make larger profits with a minimum capital.
As previously explained, Contracts for Difference enable the speculation on the rise and on the fall according to the position you take as a buyer or seller on the market. When you sell a CFD, this is basically a speculation on a fall in the asset price, and when you buy a CFD that represents a speculation on the rise in the asset price.
Fees and functions of Contracts for Difference:
When you trade CFDs online, you need to take into account the fees charged by your broker which are included in the spread, that is the difference between the best buying price and the best selling price. There again, these spreads vary from one asset to another, as well as between one trading platform and another.
However you also need to check the fees invoiced by certain brokers when you keep your position open over the long term, particularly at the market closing times.
As in the case of Forex trading, CFDs offer various trading tools such as stop and limit orders that enable you to minimise the possible risks and close your positions at the best time.
How do we know what we have gained with a CFD?
When a value that you have subscribed to using a CFD rises, your profit depends on the length of your position. When you make a good prognostic, the broker will pay you from the difference registered by the rate of the asset and when you lose, you have to pay the broker the difference equivalent to the points lost.
CFDs have a beginning that corresponds to the date and time of the contract subscription, and an end that is called the ‘date ex-coupon’. It is at this end date that you are paid or reclaimed the win or loss registered. However, in certain cases, this amount may pass through several transformations before arriving in your account. Contrary to other trading methods, you will have to be patient.
Different to other trading methods, the money you win with CFDs comes directly from your broker, the same with if you lose as the money you have lost is directly debited. It is in fact the brokerage that undertakes the purchase and sale of the real positions on the asset concerned. These sums being the dividends, this avoids having to pay specific taxes. Unfortunately this also means that you do not have the right to a tax credit on the dividends.
What are the advantages of CFDs?
The advantages of CFDs are numerous and enable beginners as well as more experienced traders to access larger sums of money than through a traditional trading intermediary. Among the greatest advantages of these types of contract we find:
- The possibility to trade a larger range of assets. Here it involves not just currencies but offers direct access to other financial and stock markets. You could, for example, decide to speculate on certain shares or indices.
- CFDs also enable speculation on the rise of rates as well as the fall in rates. At the time of the contract subscription, you should decide the direction of the trend you foresee concerning the index or asset chosen, whatever it is.
- Although CFDs require you to pass by an intermediary, here the broker, that plays the role of investor in your place, the costs involved in this type of contract remain quite low and do not present an obstacle to the capital you could possibly win.
Please note: As CFDs enable you to trade a large number of assets from different markets you should know that the opening times of the other markets are not the same as those of the Forex. To find out these times you should research the market of the asset you wish to trade.
How to trade in stock market shares using CFDs?
If you wish to trade in stock market shares using CFDs the first thing to do is create an online trading account with an approved broker. You should then deposit your investment capital in this account that you will use to take positions on the stock market.
The brokers offer you access to a large number of stock market assets including international stock market shares. You can therefore choose from a large range of assets for your speculative operations. Once you have chosen your asset you should simply take position through a purchase if you anticipate that the share price will rise, or, on the contrary, through a sale if you believe that the share price will fall.
In this way you can close your position at any time. The difference between the purchase price and sale price of your CFD represents your profit. Of course, in the case whereby the share price does not move in the direction you have anticipated then this difference represents a loss on the trade.
You can take position on several stock market share prices simultaneously and manage all your trades in real time, or use stop orders to secure your open positions and take your profits or stop your losses at the right time.