What is CFD?
The financial world seems to be full of acronyms and “alphabet soups”! There is FX, CDOs, CDSs and EPSs. Today we will explain and bring clarity to CFD trading. This is actually a quite exciting way to profit from the financial markets and many traders are not aware of the potential in CFD trading. What follows is a throughout examination of this financial instrument and the market behind these three letters.
This financial acronym stands for contract for difference (CFD). If there is a contract, than there are at least two parties. You are correct. With CFD trading there is a buyer and a seller. They close a contract between themselves, about a certain financial asset. We will explain in a short moment, what the asset is and what constitutes the contract. For now, the only thing you need to know, is that CFDs are based on assets and that the CFD is only a financial instrument to trade other assets. Another word for this kind of trading instrument is: financial derivative. This means, a trader can take advantage of price movements on underlying financial instruments, which the trader does not own. If a trader buys a contract for difference for a certain share, let’s say the share of Coca-Cola, then he is assuming a certain price movement and wants to benefit from it, without the necessity to actually buy a Coca-Cola share.
Why would someone basically buy or sell something, which he does not own? This might seem abstract to some bystanders, but this is nothing new or even strange. Investing in “abstract” or “non-existing” products is almost as old as humanity. In the middle ages a farmer had to plant the crops and wait for the harvest. In the meantime, he would have nothing to eat for his family or no money to buy other goods. He had to wait, until harvest comes around and only then could he know, if the proceedings from the sale of his crops, would cover his costs of living. One solution came in form of investors, willing to invest in a future harvest. None of the involved parties knew for sure if the harvest would be good or if a hailstorm or a plague would destroy part or all of it. This was considered the risk and part of the transaction. The landowner would sell crops, that didn’t even exist (only in the future) and the investor (buyer) would buy the crops today, for a better price. If the harvest was bad, prices would go up (because of the low supply and the great demand) and the investor could make a hefty profit.
This is one kind of financial derivative, which was born out of necessity and had actually quite practical benefits for all parties involved in the transaction. During the 90’s, Brian Keelan and Jon Wood (both working for big Banks in London) had the need to exchange equities, without actually buying the underlying asset class. The reason was simple. Both had invested in stocks at the London Stock Exchange and needed a form of hedging, to reduce the risk exposure to the stock market. The exchange of physical shares, would mean the payment of the UK tax of stamp duty. In order to avoid this payment, both banks devised a contract, which basically did the same thing.
Hence CFD trading was born! Later the practicality of this spread onto other banks, partners and soon everybody seemed to be trading CFDs instead of the actual underlying financial instrument or asset class. Suddenly, around the year 2000, some providers, brokers and traders, realized that one of the real advantages of CFDs, was not the tax exemption but the possibility to trade these instruments with leverage.
The next milestone is history. CFDs became wildly popular and soon many brokerage firms started offering them to retail traders as well. One of the big advantages for retail traders, is the possibility to trade foreign stocks, assets, indices, commodities etc. without the need to open an account in another country. Before the age of CFD trading it was a big hassle, to buy foreign stocks or shares. Traders and Investors had to go to the bank and a complicated process of transfer would begin. Only wealthy individuals or institutional firms could afford the complicated transaction process and still make a profit. Nowadays, retail traders can benefit from price movements in foreign asset classes at the “click of a mouse” – partially thanks to CFD trading.
Characteristics of CFD Trading
So, how does CFD trading actually works? What do you need to know, in order to profit from CFD trading? The first thing you need to know, is that there are many types of CFDs. Traders can participate in a wide range of market types, independently of their geographic location. The main types of CFDs are: Commodity CFDs (Oil, Gold, Wood, agricultural products, etc.), Foreign Exchange CFDs (Forex – Currency Pairs), Interest Rate CFDs (short term government notes and long term government bonds), Share CFDs (stocks of companies and corporations).
As we mentioned earlier in this article. One big advantage of CFD trading, is the possibility to benefit from price movements of the underlying asset, without the need to actually own the asset. Since this is a contract, trading by margin and with leverage is possible and even desired. We will give one example. If you wanted to buy 100 shares of Coca-Cola today (April 2016) at the NYSE (share symbol: KO), then you would need to invest 4.463 US-Dollars or the equivalent in your currency. The quoted price of one share is 44.63 US$. With a CFD contract, you are able to buy these, paying an initial margin of 5% (this depends a lot on the broker or the CFD provider! – please refer to our list of broker reviews, to find a suitable broker with good conditions). This means, that you could benefit from any price movement of Coca-Cola shares, with an initial investment of only 223,15 US$. If you buy a contract, then you are closing a contract between you and the CFD provider (in this case the broker) about the price difference that the broker is offering and the market value of the actual share. The difference is the broker profit. If the share moves up, then you will make a corresponding profit from your initial – low – investment. This is basically CFD trading in a nutshell. There are many more components to this form of trading and investing and we will cover them all in future articles on this site.
You also have to know, that there are many kinds of CFD providers. You can classify them into two categories: Direct market access providers (DMA) and Market makers. The difference is, that the DMA-provider has direct access to the local stock exchange and will deal directly with the underlying asset (like shares) and the market maker is providing liquidity, therefore giving you the price quotes and providing the market. For you, as a trader and investor, this means that you will need different margin (deposit) levels and also requirements in terms of the minimum trade value. Don’t worry about this, we have you covered with our extensive list of broker reviews and will inform you accordingly about margin and deposit requirements!
In the meanwhile, check out our list of recommended CFD brokers and providers, to see if there is one that suits your experience level and investment needs. Many CFD brokers offer modern trading software, to analyse the markets and also a comprehensive training package. Many brokers also offer the possibility of a demo account. You can trade with “play or fake” money, to train your skills and to learn the exciting possibilities of CFD trading. Please refer to our other articles about this topic and also our section on strategies for CFD trading.