CFD trading involves a contract between two parties who agree to exchange the difference in value of an asset in the time period between the opening and closing of said contract. This means that a ‘contract for difference’ can be classified among financial derivatives. Traders can speculate on shares or other financial assets without having to own the asset.
So, for example, if a Contract for Difference is bought by a trader at $20 and the underlying instrument appreciates afterwards, the trader can close the contract at a profit. So if the value goes up to $25, the trader gets $5. On the other hand, if the value drops to $15, the trader would instead have to pay the seller $5.
This may seem very familiar to futures or options traders. It is the same, but only upto the part where it’s not necessary to buy an asset to speculate on it, and because traders can work with a small margin amount and leverage it into big trades. But the main difference is that there is no expiry period, as with an option.
Another big difference is that CFD trading cannot be done in the US. This is because it is done over the counter and off the exchange, between traders and brokers or market makers. CFDs can be traded in the UK and other European nations, and also in many Asia-Pacific nations.
So let’s take a closer look at how this is done over the counter. The contracts are usually entered into between a trader and a CFD provider. This can be a market maker or broker who will set the contract terms, margin, kinds of underlying assets that can be used, etc. The traders, for their part, can choose to stick to a market maker, or do a DMA trade.
Under market-maker, the provider sets the price and there’s less of a direct link between the underlying instrument’s price and that of the contract. But under DMA, the provider has to keep a 1-1 ratio for CFDs and physical trades of the underlying instruments. This ensures the price of both the instrument and the contract remains the same.
Overall, CFD trading is a pretty simple concept. But there’s a lot to learn before a new trader can do it right in practice. There are market risks and margin calls to worry about, considering the large amounts and leveraging that goes on. A trader has to learn to use stop loss orders, and know the charges involved and the difference between equity-based CFDs and those based on indices, etc.