Contract for Differences

In the stock market, a Contract for difference is a unique kind of contract between two parties where one party undertakes to pay the other party an amount of money equal to the difference in prices of a specified security. CFDs are trading contracts whose transactions are based on the difference in prices at different times, rather than the actual prices. When trading with CFDs, it is assumed that one has bought the securities in question to resell them at the end of the contract, although that not the case because one does not actually own the securities.

In a typical CFD situation, a trader goes to a broker and buys contracts for, say, Verizon Wireless shares. Let’s say each share cost $10 at the start of the contract. The contract may last only one trading day, by the end of which the trader resells the contract to the broker. If by the end of the contract period, the prices for Verizon Shares shoots to, say $12, then the broker will have to pay this person $2 for every share traded in, as that is the difference in prices. On the other hand, if the prices drop to, say$8, then the broker is the one to be paid that amount.

Trading on differences is quite speculative, as it involves momentary changes in prices rather than long term investment outlook. In the case of CFDs, the end of the contract is usually defined from the onset.  However, such a contract usually includes a concept known as Stop-loss order.  Basically, a stop-loss order is a clause in the contract which allows one party to initiate the end of the contract prematurely when this party is deemed to be making very big losses.  A stop-loss order is meant to help control losses when the market becomes too cruel for either party. Usually, the stop loss-order price is preset from the onset of the contract, and works for both the broker and the trader.

A typical stop loss order price for the above shares would be $7 and $14, or thereabout. That means that if prices rise too high, then the broker can make the order.  Likewise, the trader can make the order if the prices fall below that ($7) point.

Perhaps the reason why CFDs are growing so popular in modern markets is because of the availability of leverage when trading with them. In a market, leverage can be likened to a loan that helps traders to broaden their trading platform beyond their capital. Since CFDs trade with price differences, it is possible to trade in more shares with less capital. Providers usually require you to deposit a specified minimum amount in your account in order to start trading.

Leverage is a good thing for traders because since you are able to trade in large volumes of shares, your profits are also multiplied many times over. However, it is important to consider the flip side too. When the market doesn’t go your way and you incur losses, the losses will be multiplied too. This is very dangerous as you might end up losing your entire initial investment.

via:http://www.whatiseconomics.org/contract-for-differences?utm_source=rss&utm_medium=rss&utm_campaign=contract-for-differences