[‘kän-,trakt far ‘di-f(a-)ran-(t)siz]
Contract for Differences is a type of agreement where the cash difference between the opening and closing trade prices is settled, without requiring the physical delivery of the underlying asset.
What is Contract for Differences (CFD)?
A Contract for Difference (CFD) is a financial derivative product that allows traders to speculate on the price movements of underlying assets, without actually owning them. It is an agreement between two parties – the buyer and the seller – to exchange the difference between the opening and closing prices of a specific financial instrument, such as a stock, commodity, currency, or index.
The basic idea behind CFDs is that the buyer agrees to pay the seller the difference between the opening and closing price of the underlying asset, multiplied by the number of units agreed upon in the contract. If the price of the asset goes up, the buyer receives a profit, and if the price falls, the buyer incurs a loss.
CFDs provide traders with several advantages, such as high leverage, the ability to trade on margin, and the opportunity to profit from both rising and falling markets. However, CFDs also carry a high level of risk, as losses can exceed initial deposits, and traders must be aware of the potential risks before engaging in CFD trading. It is important to conduct thorough research and seek professional advice before entering into any CFD trading activity.
Key Takeaways
- CFDs provide traders with an opportunity to speculate on the price movements of underlying assets without owning them, thus enabling them to profit from both rising and falling markets.
- CFDs can be used to trade a wide range of underlying assets, including stocks, commodities, currencies, and indices, providing traders with a diverse range of investment opportunities.
- CFDs do not involve the physical ownership of the underlying asset, which means that traders do not have to worry about storage or delivery costs.
- CFDs offer high leverage, which allows traders to open large positions with a relatively small amount of capital. However, it also magnifies the risk of losses.
- CFDs allow traders to trade on margin, which means that they only need to put up a small percentage of the total trade value as a deposit.
Example of Contract for Difference (CFD)
A trader believes that the price of gold will rise in the coming weeks due to global economic uncertainty. Instead of purchasing physical gold, the trader decides to open a long CFD position on gold.
The current market price of gold is $1,800 per ounce, and the trader decides to open a long CFD position, buying 100 ounces of gold at the current market price, for a total position value of $180,000.
Assuming a CFD provider requires a 10% margin, the trader would only need to put up $18,000 (10% of $180,000) as initial margin. This means that the trader has leveraged their position by a factor of 10 (the position size divided by the initial margin).
If the price of gold rises to $1,900 per ounce, the trader will have made a profit of $100 per ounce. The total profit on the CFD trade would be $10,000 (100 ounces x $100 per ounce). However, if the price of gold falls to $1,700 per ounce, the trader will have incurred a loss of $100 per ounce. The total loss on the CFD trade would be $10,000 (100 ounces x $100 per ounce).
When the trader decides to close the CFD trade, the difference between the opening and closing prices will be calculated, and the trader will receive or pay the cash difference, depending on whether they made a profit or loss on the trade.
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