What is a CFD (Contract for Difference)?
Contracts for difference (CFDs) are one of the world's fastest-growing trading instruments. A contract for difference creates, as its name suggests, a contract between two parties speculating on the movement of an asset price. The term 'CFD' which stands for 'contract for difference' consists of an agreement (contract) to exchange the difference in value of a particular stock/share, currency, index between the time at which a contract is opened and the time at which it is closed. The contract payout will amount to the difference in the price of the asset between the time the contract is opened and the time it is closed. If the asset rises in price, the buyer receives cash from the seller, and vice versa. There is no restriction on the entry or exit price of a CFD, no time limit is placed on when this exchange happens and no restriction is placed on buying first or selling first. CFDs are traded on leverage to give traders more trading power, flexibility and opportunities.
How CFD works?
First, let's go back to the definition of a CFD. A CFD is an agreement to exchange the difference between the entry price and exit price of an underlying asset. For instance, if you buy a contract for difference on SASOL at R360 and sell at R400 then you will receive the R40 difference. If you buy a CFD at R360 and sell at R330 then you pay the R30 difference.
A CFD allows a trader to gain access to the movement in the share price by putting down a small amount of cash known as a margin. Trades are conducted on a leveraged basis with margins typically ranging from 1% to 80% of the face value of the financial instrument. For indices or currencies, these margin requirements can be as low as 1 percent of the underlying value of the security.
When you enter a CFD contract you are not buying the underlying share, even though the movement of the CFD is directly linked to the share price. In fact, CFDs mirror the movement and pricing of the underlying share. However, since you do not own the share, you are only required to provide a deposit to your CFD provider/Counterparty. This means you can trade up to 10 times your initial capital and it thus possible to create significant profit through 'margin' as you only have to use a deposit to hold a position, meaning only a small proportion of the total value of a position is needed to trade allowing the client to magnify market exposure. For instance, with a stock CFD that requires a 10 per cent margin to open a trade, a 10 per cent increase in the market price of the underlying stock results in a stunning 100 per cent return on the investor's capital. However, this cuts both ways and there need only be a 10 per cent fall in the market price of the share to result in a 100 per cent loss for the investor.
CFDs do not have an expiry date like options or futures contracts. As opposed to an expiry date a CFD is effectively renewed at the close of each trading day and rolled forward if desired - you can keep your position open indefinitely, providing there is enough margin in your account to support the position. In this stance contracts for differences are very similar to futures without an expiration date. While the contract remains open, your account with the provider will be debited or credited to reflect interest and dividend adjustments.