Introduction To Contract For Differences: cfd

Cfds are derivative instruments that allow investors to gain exposure to an underlying instrument without taking physical ownership or possessing certain rights of ownership. As the name implies, contract for differences is essentially a contract between a client (you) and a broker to exchange the difference between the opening and closing value of the underlying instrument at a future date.

Until recently, CFD trading was carried out almost exclusively by City professionals. However, they have since been made available to retail investors who have taken to the product very quickly such that the instrument is now one of the fastest growing financial products, representing a significant proportion of total equity volume in the London market.

CFD trading is now common place even among small private investors. When you trade CFDs, you are basically speculating on the direction of the future price movements of the particular underlying instrument. Typically, the contract is open-ended. When you decide to close the contract, your profit or loss is simply the difference between the opening price and closing price of the underlying instrument.

Put in another way, when you buy shares through a broker in anticipation of a rise in value, you would have to sell to realise the increase in value. So, if you had bought at 100p per share and then sold at 150p per share, you get the difference of 50p per share (less transaction costs such as commissions). CFD trading is designed to simplify this process so that the transaction only involves an agreement to settle the difference between the price at which you enter the position and the price at the time you decide to close the trade. Hence the name 'contracts for differences'.

While CFDs can be structured to match any underlying financial instrument, the most common ones are designed to mimic individual equities and global equity indices.

Whether they are based on share or indices, the key feature of contract for differences remains the same. CFDs give the investor an equivalent economic exposure to buying or selling the actual physical security. Hence, if you are short an equity CFD, then as the price of the underlying share falls, the value of your contract increases.