Being an abbreviation of Contract For Difference, the term CFD relates to a tradable financial instrument. A CFD is known as a ‘synthetic’ instrument because the investor holding the CFD does not actually go out and buy the underlying asset in the market but instead instructs an agent to act for them in managing the CFD on their behalf.
How they work
The end user enters into a Contract where they take on the profits or losses (P&L) associated with price moves of the underlying instrument. They have a Contract For (the) Difference between the value of the underlying instrument from the time they open the contract to the time they choose to close it. The end user, not the broker platform, will thus be responsible for any profits or losses associated with the trade.
Reasons for the existence of CFDs are many and varied but mainly stem from the fact that a particular agent in the market, maybe a large broker, a bank or a trading platform, can hold and manage the underlying position more efficiently than can end users. In some instances, access to markets may be restricted to individual traders.
As the holder of the CFD position is not actually in possession of the underlying instrument, there are some differences in what they can and cannot do. If you hold a CFD that has an equity as its underlier, it is unlikely that you will receive dividends associated with the stock. Taking a purchase (long position) as an example, the broker platform will record that it has gone into the market to make the trade and the cash used to do that will be recorded as a negative balance on your trading account that will incur financing costs each day the position is active.
CFDs have two more particularly interesting features that offer opportunities and risks to individuals looking to trade:
CFDs are a type of leveraged product in that they allow traders to have greater access to the market without having to increase their level of capital investment. The investor is not required to deposit funds equating to the total value of the transaction. Instead they place a margin (initial portion of the position) with the other party such as a trading platform. In that way they can gain exposure to a larger trading position than they might otherwise be able to. However, trading on margin can result in the full benefits of the position being experienced with profits but can also magnify any losses for the trader.
Taking an example of a UK listed company using CFDs means it is possible for the individual trader to ‘sell short’ a particular name. The Contract will in this instance result in profits for the individual if the market price of the underlying instrument goes down.
CFDs originated in the 1990s in the London equity market, but modern Broker Platforms now offer CFD trading across a wide range of underlying instruments including, but not limited to; commodities, bonds, market indices, shares, forex and cryptocurrencies. Because the underlying instrument is not owned, UK stamp duty is not payable on any profits.
The terms associated with trading CFDs differ somewhat across the respective broker platforms and comparison can be made using Broker Comparison.
The online interfaces used for trading CFDs look something like the illustration below. Traders can enter the quantity they want to trade and click on buy or sell in line with their chosen trading strategy. The below is taken from the demo account of City Index and shows that at the time of trade there is also an opportunity to set limit orders and stop losses.
By clicking on ‘Place Trade’ the trader instructs the broker to buy 200 Sainsbury CFD at 303.6 with a stop loss price of 264.