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A contract for differences, or CFD, is an agreement between an investor and a provider to exchange the difference in value of a financial product between the time the contract opens and closes.

The investor never actually owns the underlying asset, but rather, receives revenue based on the market changes of that asset. If the asset’s value rises, he’ll receive a profit. If it decreases, he takes a loss. Essentially, the investor is predicting performance.

Sarah believes Stock A is going to rise. She decides to enter into a contract with a CFD broker. She agrees to buy 100 shares of Stock A at $10 a share. The CFD broker requires Sarah pay only 5 percent to enter the contract, so she pays $50.

As Sarah expected, Stock A increases in value. On closing day, she sells it and pockets the difference in value as profit.

The advantages to CFDs include lower margin requirements, meaning access to the underlying asset at a smaller financial commitment than buying the stock outright. It also provides access to a variety of global markets and indices, lower fees, ease of execution, and the flexibility to go long (buy) or short (sell) on an asset.

Disadvantages include market risk, which grows amid volatility. And when entering a CFD, the investor’s initial position is reduced by the size of the spread – the difference between the asset’s ask and bid prices – which can trim profits.

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