Normally, when you make investments, you buy assets on the open market – for example, you might buy stocks, commodities or currency pairs. However, it is also possible to make investments without owning an asset at all – in fact, this is becoming an increasingly popular way of investing. This type of investment is known as a contract for difference (CFD), and is essentially a contract between yourself and a CFD broker like ourselves.
How CFDs work
Basically, a CFD looks at the difference between the price when you enter a position and when you exit. For example, let’s assume that stock A is trading at $17.50 and you enter into a CFD trade with your broker. The price then goes up to $19.50. You then exit your position and take your $2 profit. This is exactly the same profit you would make if you had bought the stock and then sold it. However, you haven’t – your broker is paying you directly, without anyone actually purchasing the stock. Of course, if the stock goes down, you end up losing and paying your broker instead.
Understanding the spread
Actually, the amount you make on a CFD isn’t exactly the difference between the entry and exit price. When you first enter into a CFD trade, you will see that you are in a small loss position. This is the spread, and it is how the CFD broker makes money. For instance, you might find that the spread is $0.05, so initially your CFD will show a corresponding $0.05 loss. The stock price then has to rise by $0.05 for you to break even. Note that spreads with CFD brokers are often higher than you would find in a normal bid/ask spread in the market, which can be a disadvantage if you are trying to trade on small price movements.
“Basically, a CFD looks at the difference between the price when you enter a position and when you exit.”
CFDs offer higher leverage
One key reason why CFDs are becoming more popular is that they offer higher leverage than traditional stocks and other assets. This is because they are not subject to the same regulatory restrictions that apply to actual assets. You are not buying or selling assets, so these rules do not apply.
For instance, let’s come back to stock A. You want to buy 1,000 shares, so that will cost $17,500 at $17.50 a share. If you actually buy the stock, then your traditional broker will give you 50% margin. This means that you have to come up with 50% of the cost in cash – or $8,750. However, a CFD broker will often let you operate with as little as 5% margin, so you only have to come up with 5% of $17,500 – or $875 in total. This means that you can take larger positions with less capital, which increases your profit potential – although it also increases your risk.
CFDs have a number of other advantages that make them very attractive. First of all, since you are not buying or selling real assets, CFD brokers can offer products from all major markets around the world – everything is just a local contract between you and them. Second, you avoid any regulatory restrictions on short selling, and also don’t have to pay to borrow money when you short a stock through a CFD. Third, CFD brokers typically do not charge commissions – they make their money on the spread. Not only that, but CFDs are usually not subject to transaction taxes such as stamp duties, which makes them even more attractive in jurisdictions where these taxes are imposed.