A contract for difference, or CFD, is an agreement between a buyer and seller that is based on the price of a stock or other financial asset at a certain time in the future. If the price of the security has increased when the contract is up, the seller of the CFD pays the buyer. If the value goes down, the buyer pays the seller. But beware: scammers often employ CFDs as a part of schemes to take advantage of retail investors, according to securities regulators.
It’s always wise to take advantage of the insights and experience of a professional financial advisor before investing in high-risk securities.
CFD: Definition, Risks, Uses
CFDs are a specific type of derivative known as a swap. Their value is based on the value on an underlying asset. The asset may be shares of stock, a market index, a commodity or other financial instrument. Trading in CFDs is also known as spread trading, because those who trade them have to pay the difference – known as the spread – between the buy and sell prices.
CFD trading is highly risky, with traders essentially speculating on the future direction of prices. CFD trading is also done on margin. That means traders only have to put up a small fraction, often around 10%, of the actual value of the position. This high leverage means CFD traders can lose much more than the value of the trade, up to and including their entire position.
For this reason, only high-net-worth individuals, experienced traders and institutions typically make use of CFDs. Unsophisticated retail investors trade CFDs only at their own peril. Some trading platforms report that nearly three out of four retail investors who trade CFDs lose money on their trades.
However, for those with the financial capacity and experience to use them, CFDs can offer a lot of utility. For one thing, since investors aren’t actually buying the underlying assets, CFD trades escape most taxes levied on profitable trades in stocks and other securities.
Also, these derivatives can be used to hedge against portfolios consisting of the actual shares of stock or other instruments. By selling a CFD on those shares, the trader is betting that the share prices will go down. If they do, the profit on the CFD trade can recoup some of the value lost by the shares in the investment portfolio.
How CFDs Work
As an example of how a CFD trade might go, an investor might enter into a CFD on a company with a share price of $10. If the CFD is for 1,000 shares, the value of the position is $100,000. However, because of leverage, both buyer and seller put up only $10,000 each. If the price of the shares goes to $11 on the contract date, the buyer will get $1,000 from the seller. That is the $1 difference between the initial share price of $10 and the ending share price of $11, times 1,000, which is the number of shares covered in the contracts. If the price drops to $9, the buyer pays $1,000 to the seller. Again, this is the $1 difference in the share price, times the number of shares covered in the contract.
This is a simplified example that doesn’t include all costs. While CFDs are not subject to as many taxes as trades involving actual shares, they are subject to commissions and fees. Traders typically pay commissions on opening the position as well as closing it.
Also, while CFDs can be traded on individual stocks, they can also be based on the value of assets such as commodities, indexes, foreign exchange and Treasury notes. CFDs can also be based on differences in the prices of two or more stocks in a basket.
Bottom Line
Contracts for difference are highly speculative, high-risk derivatives trades that affluent, sophisticated investors can use to bet on what the price of an underlying security will be at some point in the future. CFDs can be used to hedge portfolios. They also offer tax advantages compared to owning the actual assets they represent. Because they are traded on margin they can result in big profits and losses, even beyond the cash put up by traders. Scammers sometimes use CFDs to take advantage of retail investors, according to securities regulators. So beware of promises of quick wealth, pressure to wire money offshore and attempts to get you to attend seminars or buy special software.
Tips on Investing
- If you are a retail investor and considering engaging in contract for difference trading, an experienced financial advisor can help evaluate if this high-risk strategy is a good fit for you. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Whether you’re considering getting started with investing or you’re already a seasoned investor, an investment calculator can help you figure out how to meet your goals. It can show you how your initial investment, frequency of contributions and risk tolerance can all affect how your money grows.
Photo credit: ©iStock.com/mapodile, ©iStock.com/yongyuan, ©iStock.com/sankai