Trading in Contracts for Difference (CFD) allow you to make a profit from price movements without actually owning any of the underlying assets. Your counterpart is the CFD broker, so the word broker is used rather loosely in this context. When the CFD broker is creating CFD, it is not really a brokerage service – the “broker” is simply creating and selling CFD.
Contract for difference
What is a contract for difference?
The contract is established between the buyer and the seller, and the difference refers to the difference between the market price (strike price) of the underlying asset at the time the contract is entered and the market price (strike price) of the underlying asset at the time when you close the contract.
Example: You believe that the commodity price of crude oil is going up. Instead of purchasing actual crude oil or crude oil options, you purchase a Contract for Difference where the seller promises to pay you the difference between the oil price today and the oil price when you close the contract, provided that the oil price is higher when the contract is closed than today.
A Contract for Difference is thus a derivative product.
The underlying assets
Almost any underlying asset can be used when brokers create Contracts for Difference. Examples of commonly utilized classes of underlying assets are equities, commodities and currencies. Even an index can be the underlying of a CFD.
A typical CFD doesn’t have a fixed maturity date. It is up to the owner of the CFD to decide when to exercise the CFD.
In theory, owners can hold on to a CFD for virtually any time frame. In reality, a vast majority of all purchased CFD are exercised within a week from being purchased. Some get a very short lifespan and are only kept open for a few hours or even less.
What if I think the market is going down?
One of the appeals with Contracts for Difference is that you can make money even when markets are going down. Instead of buying the type of CFD that gives you a reward if the price of the underlying goes up, you simply buy the type of CFD that gives you a reward if the price of the underlying goes down.
Warning: Your losses can exceed your initial investment if you use leverage
Contracts for Difference is typically offered as a linearly leveraged financial product. This means that you can risk more money than what you have available in your account with the broker, and you can end up with a huge debt to the broker.
Using leverage is appealing since it will allow you to make large trades and make it easier for you to yield a nice profit even from tiny price movements. It is however very important that you inform yourself about the risks associated with leveraged purchases.
With a CFD, profits and losses increase in direct relationship to market performance.