Contracts for difference (CFD)
Contracts for difference is a financial instrument that is traded online by market investors. The investors of the CFDs are two parties who buy and sell the underlying security for generating profits. In the CFDs, the difference between the opening and closing price of the security is the profit and loss that the traders incur.
The buyers and sellers of the CFDs trade in the security of various markets such as stocks, forex, commodities, indices, metals, etc. Mainly, traders speculate on the CFDs and avoid the risk of purchase. As the CFDs are based on the contract time price and the current price of the security, it is favourable to speculate then buy and sell.
CFDs are the derivative products; the term derivatives mean that the value of the contract is derived from the performance of the underlying security. These were developed in the late 1990s as an equity swap in London. It is traded on margin and is a good option for traders with small investments.
Traders do not require to physically purchase the underlying security; if the difference of the contract is positive, the seller pays to the buyer, whereas if the difference is negative, the buyer pays to the seller. These also mirror the corporate actions, stocks and indices that take place in the market.
In CFD trading, investors can use the following:
- Short and long term trading
How do CFDs work?
CFDs work on the key four concepts explained below; with an understanding of the CFDs, it is also important to know how to operate them. The four factors to trade CFDs are spread and commission, deal size, duration and profit/loss.
Spreads and Commission
The CFDs work on the factor of spreads, that is, the bid and the ask price difference. The bid price is the selling price at which traders open a short market position. On the other hand, the ask price is the buying price, also known as the offer price. Traders open at the ask price and open a new long term trade position with CFDs.
The bid and the ask price are the quoted price that helps traders decide over the investments. The selling price always stays a bit lower than the current market price of the underlying security. In contrast, the buying price is higher than the current market price. Thus, traders use spreads as a significant factor in trade.
The CFDs are open with the spreads included with the price of investment to trade. The buying and selling prices of CFDs are adjusted, which reflects the price of the CFD. The share/stock CFDs are not charged with the spreads and are an exception for the stock traders. However, these have a commission charged for the trade.
The CFDs are traded in lots; the size of the traded underlying security is vital for the trade. So, traders should consider the trade lot size of the CFDs for investing and according to their market investment.
The duration of trade of CFDs has no expiry date; they are traded either for the short term or the long term. Traders place the trade in the opposite direction by opening a position on the opposite side.
Profit and Loss
The traders calculate the profit and loss by using the deal size of the position held by the trader. Traders multiply the deal size via the value of the contract and then multiply it with the difference of the closing and opening price of the security.
Stocks are the shares of a company traded by the stock exchange and invested to make high profits on the stocks. The shares provide traders with ownership of the company. This gives them the position of the shareholder with the right to vote and attend the meetings.
The stocks are of two types, equity shares and preferential shares. The equity shares have the right to vote and attend the meeting. Whereas the preferred shares do not provide voting rights.
Investing in the stocks is highly profitable as traders, along with the profits, also earn dividends provided by the companies. The dividend is the revenue that the company earns from the shares in the market. Traders should analyse the market of the stock and the company information before investing in any company.
If it is analysed and used with strategy and trading tools, traders will have a profitable investment. The traders get a certificate for the stock purchased and can further sell them in the market. Even traders can speculate, use it as a derivative with the CFDs or options and trade normally.
Difference between CFD and Stock
The trading of CFDs and stocks are different as the two trade instruments are different from each other. CFDs are derivatives that can be used with stocks. In contrast, the stock is the shares of a company that provide ownership and could be invested depending on the company’s market position.
- CFDs have the benefit of leverage, but stocks do not have this facility for the traders.
- The stocks have a dividend which is an extra earning for the trader, but CFDs do not have a dividend on them.
- The stocks provide traders with ownership, and CFDs do not have such a facility; these have only speculation on the underlying assets.
- The range of markets to trade in CFDs is multiple markets, but stocks can be traded with ETFs and equity.
- The stocks have a commission on their trading, but CFDs have spreads and holding costs.
- CFDs could be traded 24 hours and five days a week, but stocks are traded during the stock exchange opening hours only.
- Traders of stocks enjoy voting rights in companies, and CFDs have no such option.
Stock and CFDs are two essential trade instruments and are quite productive for traders. However, these are different in their functioning; one is a company share, and the other is a derivative product. Investors can use both for trading but should be aware of the use. For accessing the markets and instruments of stocks and CFDs, traders can create a brokerage account with online brokers such as Investby.