Contract for Difference (CFD) – Meaning
A contract for difference is an arrangement wherein a buyer and a seller enter into a trade contract for an underlying asset. CFDs are not traded on official exchanges; instead, they are instrumented by brokers. So the counterparty is a broker, which means if a trader sells, then the buyer is a broker and vice versa.
Furthermore, the underlying asset of a CFD can be global indices such as NASDAQ, Nifty, etc.; currency, gold, commodities such as wheat, corn, etc. This contract allows both parties to trade the underlying asset without actually possessing the said asset.
Finally, CFDs are traded on margin; one doesn’t need to pay the full amount of purchase to conduct a CFD trade.
So the question now is, “How does a contract for difference work?”. As a concept, it is a little complicated to understand the workings of this instrument. So let’s understand this concept with an example.
Example of Contract for Difference
Mr. Sam, a regular trader, believes that the price of gold will increase by 10% in the next one year and wants to benefit from this price increase. He decides to buy gold CFDs. The opening price of gold CFD on January 1, 2018, is USD 1350.00 per oz. Sam decides to buy 100 oz. of gold in CFD by paying the current margin of 10%.
Therefore the trade would be –
Purchase value = USD 1350 X 100 = USD 135,000
Margin that Sam has to pay to buy this gold CFD = USD 135,000 X 10% = USD 13,500.
However, contrary to Sam’s assumption, the price of gold actually declines. On August 16, 2018, the price of gold declined to USD 1190 per oz. In this scenario, Sam has two options as follows –
- Option-1 – Pay an additional margin to maintain his position
If Sam still believes that his prediction of a 10% increase is correct and the current decline in price is temporary, he may want to hold his position till the closing price. In such an instance, he has to pay an additional margin as the price of gold has declined.
Sam had paid a margin of USD 13,500 as per the January rate. As per the current August rate, his margin has declined to USD 11,900 [(Price per oz. USD 1190 x quantity 100 oz.) x 10%].
Thus Sam has to pay USD 13,500 – 11,900 = USD 1,600 to bring his margin up to the current level and maintain his purchase position.
- Option-2 – Sell off his position and cut future loss
If Sam assumes that his prediction was wrong and the current decline in gold price is here to stay, then he might consider selling his position and cutting his losses. In such a case, he sells his gold contract of 100 oz. at USD 1190 per oz.
Therefore he gets = (USD 1190 X 100) X 10% = USD 11,900
This means, instead of his initial margin payment of USD 13,500, he now receives USD 11,900 as margin repayment. Thus his loss amounts to USD 1600.
This is just one example of a contract for difference. There can be many combinations to this contract. The trader can take the position of a buyer or a seller, which means his contract can be long or short. Whether the trader makes a profit or loss depends on the trader’s position and the direction of the price of the underlying asset.
Let’s note down the scenarios to understand when does a trader makes a profit and when does he suffers a loss.
Scenarios of Contract for Difference
- Long Position
When a trader believes that the underlying asset’s price will increase in the future, he can open a long position. The trader has to buy the contract and hold it until the price increase. When the price increases, he may sell the contract for a higher closing price and make a profit.
- Short Position
If the trader believes that the underlying asset price will decrease in the future, he will take a short position. In this, at the opening price, the trader sells a contract, and when the price decreases, he buys the contract at a lower closing price and makes a profit.
It is good to understand the advantages and disadvantages of a contract for difference, to get clarity about the working of the instrument. Let’s look at some of the advantages and disadvantages in detail.
Advantages of Contract for Difference
CFDs provide the trader an opportunity by investing a lesser amount and targeting higher profit. As the trader only has to pay a margin on his contract, he is actually leveraging his investment manifolds. As shown in the previous example, Sam entered into the CFD contract, and he could buy 100 oz. of gold for USD 13,500, had he entered into a regular trading contract, he would be able to buy only 10 oz. of gold for USD 13,500.
No Ownership of Underlying Asset
A great advantage of a CFD contract is that the trader doesn’t need to possess or take ownership of the commodity that he wants to trade-in. In our previous example, imagine Mr. Sam having to safely store a 100 oz. of gold till the trade is completed. It is practically not possible to make bulk trade of commodities if one has to take possession of those commodities. Thus CFD creates an additional opportunity for the traders.
Cheaper Trading Instrument
In a CFD, the trader can trade on margin so that he will require less capital. This, in turn, reduces the opportunity cost of his capital and borrowing cost. Furthermore, few fees or, in some instances, no fees are charged from the trader to trade in CFDs. This is because the broker makes money from the spread that traders pay.
Due to these reasons, a CFD is a cheaper trading instrument than other instruments such as stock.
Disadvantages of Contract for Difference
There are entry and exit costs attached to the contract for difference. Therefore it is not possible for traders to take advantage of small ups and downs in the prices. This inflexibility leads to a loss of opportunity for the traders.
A contract for difference is highly speculative in nature. Due to the leverage attached to these contracts, there is a high chance of making high profits. However, it comes embedded with a chance of incurring heavy losses. Also, CFDs are not very highly regulated. Thus the brokers don’t work on credibility but on their own reputation. All these factors add up and make the contract for difference a comparatively risky investment.