CFD’s are increasingly popular as an investment for individuals. In this article you can read what CFD’s are. CFD stands for ‘Contract For Difference’. A contract for difference is a financial instrument in which two parties agree to settle the difference in value of an underlying good between now and the future. That sounds complicated, so let’s look at the parts of that definition
- A financial instrument. A CFD is an investment, just like a stock or an option. It is intended to make a profit or return, with the investor taking a certain amount of risk.
- An agreement between two parties. CFD’s are a private agreement between the investor and the broker. They are not traded on a central exchange.
- On an underlying good. A CFD is always agreed on a product whose value fluctuates, and whose value can be objectively determined (for example by means of the stock price). The underlying good can be anything: a foreign currency, a commodity such as oil or cotton, a stock, a stock market index, and so on.
- The difference in value between now and the future. The difference in the price of the underlying good between the time the contract for difference is entered into and the time it is terminated.
- To be settled. If you buy a CFD on the Unilever (long) share at a price of 40, and sell it at a price of 45, the broker pays you 5 profit. If the share had dropped to 35 then you have to pay the broker 5.
An important characteristic of CFD’s is that you do not actually own the underlying good. You only agree to offset the change in value, as if you had owned the asset. You conclude this agreement through a CFD broker (‘What is a broker?’). There is no expiration date or fixed time when the contract is terminated. Only when you expect that there is no further return to be made on the underlying good, you close a CFD (just like you would sell a stock).
CFDs are a good investment to make money off of the short term changes in value in financial markets. With stocks, it can take months to make a few percent return. With CFD’s this is a matter of days (or less). With a small amount you can already trade in large positions (that is due to ‘leverage’) and you can always determine the maximum risk you run. That is why more and more investors are choosing to trade CFD’s.
Example of a CFD
An example. You buy a contract for difference on the Heineken share from a CFD broker. The contract you conclude is a so-called ‘long’ position. This means that you speculate on appreciation of the share. (The opposite is a ‘short’ position; you assume a fall in value.) When you buy the CFD, the Heineken price on the Amsterdam stock exchange is EUR. 41.00. You buy a CFD on 100 shares. You do not really need to buy 100 shares (that would cost you 4,100 euros), but you only need a fraction of that amount (often 1/50 – 1/20) to cover potential losses. For example, for 100 Heineken shares you have EUR. 82.00 needed. This amount is set aside. A day later, the Heineken share increased by 1.5% to EUR. 41.62. You decide to take your profit and sell the contract for difference (you can do this at any time). The CFD broker with whom you have concluded the contract pays you 100 times the difference in value of EUR. 0.62 off, which gives you a profit of EUR. 62.00. While the stock has only gone up 1.5% in value, you have made a 75.6% return on your set aside capital. Not bad for one day of investing
The popularity of CFD’s
CFDs were first introduced in the late eighties of the last century. (Read more about the history of CFDs.) They are now an indispensable investment product. What makes CFDs so popular with investors? CFD trading is active investing. You can make new decisions every day that affect your return. This makes CFD trading much more interesting than passively buying stocks, bonds or mutual funds. With CFDs you can achieve much higher returns than with other forms of investing. Leverage allows you to benefit from small price fluctuations behind the decimal point. You can trade CFDs 24 hours a day, at home, from the comfort of your home. The advanced software of CFD brokers makes it possible to place orders directly from the price charts. Whether prices are rising or falling, you can always make money with CFDs. Because you can speculate on both a rising and a falling stock (by taking ‘long’ or ‘short’ positions), you are not dependent on the direction the market is heading.