CFD (Contract for Difference) is primarily a tool that
allows you to «derive» profit (hence the term «derivatives») from changes in the
price of an underlying asset, no matter whether the price rises or falls. The
underlying asset in question may be shares, bonds, futures, currencies,
commodities, etc. Essentially, CFD is a kind of copy, or «clone» of the
underlying asset. It is an agreement between two parties to exchange the
difference between the sell and buy price of a contract, multiplied by the
quantity of units of the underlying asset as stipulated in the contract. This
instrument is a product of the «Over-the-Counter» (OTC) market.
Who should be interested in CFD trading in the first place and what are the
advantages of CFD trading?
Why did CFD contracts emerge if it is possible to trade in the underlying
asset directly? The main objective and advantage of CFD is that it provides
traders with the opportunity to derive profit from changes in the price
of an underlying asset while not directly «possessing» that asset. It does this
by lifting some of the regulatory restrictions (mainly stemming from the amount
of deposits required) on directly operating in the underlying market. Hence,
with CFD dealing, a trader is able to obtain the same financial result they
would as if dealing on the underlying market directly. Hence for beginner
traders CFD is a crucial tool that will allow them to start electronic trading
in underlying assets with a relatively low deposit at a correspondingly low
risk, yet still with real money (a very important factor in preparing
psychologically for trading).
CFD allows a trader to take long or short positions on an asset and also the
underlying contract. The relative ease with which it is possible to take long
or short positions broadens significantly the investment capabilities
of a trader, who can now derive profit from both a price rise and fall. For
example, to open a position per a futures gold contract on the New York Stock
Exchange, it is necessary to have at least 5,000 US dollars
(the so-called «initial margin»). What should a trader do who
analyzes the market and would like to capitalize on his knowledge, but does not
have the available funds to do so (i.e. wants to start trading in gold)?
It is exactly this trader for whom CFD trading will prove useful because trading
CFDs is based on margin, i.e. to conduct a transaction it is sufficient to have
on average only 5 to 10 percent of the full contract value. The chance
to operate not only through entire lots but also fractional lots (up to one
tenth of a standard lot), reduces capital requirements for trading in the
underlying market by a factor of 10.
In summary, the main objective of CFD is to meet the demands of customers
with a relatively low deposit who would like to trade in capital intensive markets.
