Introduction
A Contract for Difference (CFD) is a popular form of derivative trading. In finance, CFD’s (or contracts for differences) are contracts between two parties, typically described as “buyer” and “seller”. This stipulates that the seller will pay to the buyer the difference between the current value of an asset and its value at contract time.
Uses
The CFD offers European traders and investors an opportunity to profit from price movement without owning the underlying asset. Contracts For difference trading enables you to speculate on the rising or falling prices of fast-moving global financial markets, such as forex, indices, commodities, shares and treasuries. For more information see CFDs Made Simple: A Beginner’s Guide to Contracts for Difference Success by Jeff Cartridge and Ashley Jessen.
Contract for Difference in Use
CFD Mechanics
A CFD is accomplished through a contract between client and broker, and does not utilize any stock, forex, commodity or futures exchange. It’s a relatively simple security calculated by the price movement between trade entry and exit, computing only the price change without consideration of the asset’s underlying value.
Advantages
CFD trading offers several major advantages that have increased their popularity in the past 20 years. Simply, Contracts For difference trading lets you speculate on the price movement of a host of financial markets and products such as indices, shares, currencies, commodities and bonds. The trader can easily initiate both long or short positions to profit from rising or falling markets. Speculating on price movement rather than owning the underlying instrument means the trader is not liable for UK Stamp Duty on any profits.
Contract for Difference Example
How to Trade Contract for Difference
In this example we use a UK based Company and currency as CFD’s are not available in the USA. A quote from Plus500 shows us Glaxo is trading at 1,600 – 1,610. That is, 1,600 pence is the sell price and 1,6100 pence is the buy price. Hence, the spread is 10.
The trader decides to open a long position by buying 1,000 CFDs, 1,610 pence. If the commission is 0.10%, the total commission is
1,000 * 1,610 * 0.10% = £100.
If Glaxo has a margin rate of 3%, then you only have to deposit 3% of the total value of the trade as position margin. In this example, the margin will be
1,000 * 1,610p * 3% = £483.
If the stock rises by 50p the CFD quote will move to 1,650 – 1,660. The trader can now sell and realize a profit of 40 x 1000 CFD’s less two sets of commission = 200 GBP. This produces a return of 41.41% on the initial investment of 483 GBP.
