Contract For Differences - CFD

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What is a 'Contract For Differences - CFD'

A contract for differences (CFD) is an arrangement made in a futures contract whereby differences in settlement are made through cash payments, rather than by the delivery of physical goods or securities. This is generally an easier method of settlement, because both losses and gains are paid in cash. CFDs provide investors with the all the benefits and risks of owning a security without actually owning it.

BREAKING DOWN 'Contract For Differences - CFD'

The CFD is a tradable contract between a client and a broker, who are exchanging the difference in the current value of a share, currency, commodity or index and its value at the contract’s end.

Advantages of a Contract for Differences

CFDs provide higher leverage than traditional trading. Standard leverage in the CFD market is as low as a 2% margin requirement and as high as a 20% one. Lower margin requirements mean less capital outlay and greater potential returns for the trader. Also, the CFD market is not bound by minimum amounts of capital or limited numbers of trades for day trading. An investor may open an account for as little as $1,000. In addition, because CFDs mirror corporate actions taking place, a CFD owner receives cash dividends and participates in stock splits, increasing the trader’s return on investment.

Most CFD brokers offer products in all major markets worldwide. Traders have easy access to any market that is open from the broker’s platform. Because of stock, index, treasury, currency, commodity and sector CFDs, traders of different financial vehicles benefit.

The CFD market typically does not have short-selling rules. An instrument may be shorted at any time. Since there is no ownership of the underlying asset, there is no borrowing or shorting cost. In addition, few or no fees are charged for trading a CFD. Brokers make money from the trader paying the spread. A trader pays the ask price when buying, and takes the bid price when selling or shorting. Depending on the underlying asset’s volatility, the spread is small or large and typically fixed.

Disadvantages of a Contract for Differences

Paying the spread on entries and exits prevents profiting from small moves, while decreasing winning trades and increasing losses by a small amount over the underlying asset. Since the CFD industry is not highly regulated, the broker’s credibility is based on reputation rather than life span or financial position. Because each day a trader holds a long position costs money, a CFD is not suitable for buy-and-hold trading or long-term positions.

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