CFD
More and more, investors are becoming aware of the product called cfd due to heavy promotional efforts from brokers. Before engaging into cfd trading, each investor should ask himself: what is a cfd exactly? Cfd stands for contract for difference. They are derivatives which are not traded on an exchange. Instead they are traded in what is called the OTC-market (over-the-counter market). Cfds are the result of financial engineering for leverage and tax avoidance purposes.
Cfd mechanism
The mechanism behind cfds are simple and already suggested by its name: contract for difference. In essence, when investors enter into a contract for difference, no investment has to be made. For example, investors can enter into a cfd contract for 1000 $ with no initial investment instead of buying the share for a 1000$. At the end of each day, the difference between 2 sequential closing prices is determined, and the difference between the 2 is cash settled. Another advantage is that investors have the possibility to go both long and short in a cfd contract. The received or payed cash flow thus depends on the price change, positive or negative, and the position, long or short.
CFD and leverage
Another advantage of these contracts is that it allows trades to take leverage by trading on margin. The amount that should be held on margin depends from broker to broker. This thus enables traders to earn a multiple of his investment without putting up the whole amount of money if the underlying moves in the desired direction. Of course, there is the risk that the underlying moves in the opposite direction. This will trigger at some point a margin call, which should be honored. If not, the broker will automatically close out the position resulting in a loss for the investor.
CFD trading costs
There are different costs associated to cfd trading which investors should be aware of. These costs are: the commission, the spread and an interest rate. The first cost that is charged when making a transaction, opening or closing a contract, is the commission. This is the amount of money that is charged, fixed fee or x% of the contract size. The second cost is the spread, which is the difference between the best bid and ask price for the cfd contract. Opening and directly closing a contract thus results in an immediate loss due to the spread. What also should be kept in mind is that some brokers don’t charge any commissions. However, the spread on cfds they offer is often much higher. The last cost charged in the interest rate. This cost is charged because the broker will hedge your position with you by either buying the underlying if you took a long position for which needs to be financed. Or shorting the underlying if you have a short position for which it needs to borrow shares and pay a lending fee. A good selection of a cfd broker thus involves the trade-off between commissions, spreads, and the interest rate.
Summary
Cfds are derivatives traded on the OTC-market. They allow investors to take leverage, avoid taxes, invest in otherwise inaccessible markets, and both take long and short positions.