How Contracts For Difference Work

Contract For Difference or CFD is a contract between buyer and seller to pay the difference between opening and closing value of the underlying instrument in cash when contract is terminated. The main advantage of CFDs over futures is that they can be sold or bought back at any time at the value set by the stock market.

Unlike conventional share trading where you pay the full amount of the shares value with CFDs you only make a small payment (about 10% of the underlying asset value) via your broker to guarantee that you meet the obligations of the contract. This is called margin and you are required to maintain it at all times. If the trade goes the wrong way you will be asked for more money to restore your margin requirements.

The easiest way to understand trading in CFDs is to look at it as buying shares (or any other asset) with a short-term loan from your broker. You get a loan and pay interest on the borrowed amount on a daily basis. When you terminate the contract you pay off the debt and pocket the profits. As contract for difference is a margined (or leveraged) trading instrument your profits are magnified, the same applies to your losses as well and you can lose more than your initial margin.

Let's have a look at a simple CFD trade of shares of HSBC Plc with 10% margin requirement:

CFD Trading Example:

Winning Trade	Losing Trade
1. HSBC shares are trading at 700p at which you can either sell or buy.	1. HSBC shares are trading at 700p.
2. You think that the price will go up and buy a contract for 1,000 shares (if you were to buy the shares you'd have to pay £7,000 but with CFDs you have to pay only £700.	2. You think that the price will go down and sell a contract for 1,000 shares.
3. Your expectations are correct and stock rallies to 735p.	3. Unfortunately, your expectations are wrong and shares go up to 735p.
4. Close the contract at 735p.	4. You close the contract at 735p.
5. After paying about £30 commission your profit is (735p - 700p) * 1,000 - £30 = £320.	5. After £30 commission your gain is (700p - 735p) * 1,000 - £30 = -£380.

As we can see from the examples leveraged trading can be dangerous and should be treated with extra care, at the same time presenting great profit opportunities. Also remember that CFDs are traded in the currency of the underlying assets, thus S&P500 shares will be traded in US dollars whereas shares in FTSE will be traded in GB pounds.

With CFDs there's no expiry day and thus they can be held for unlimited period of time but long positions come at a cost as you have to borrow the money from your broker. The important point to notice from the above example is that you borrow £7,000 and not £6,300 as £700 is an initial margin and is used to guarantee that you meet contract obligations. On average brokers will charge LIBOR + 2% for long positions and pay LIBOR - 2% for short positions. As of this, short positions will also pay you interest as technically you lend money to your broker.