Contract for difference

What Is Contract for difference?

A contract for difference (CFD) is a popular form of financial derivatives trading that allows individuals to speculate on the rising or falling prices of fast-moving global financial markets, such as shares, indices, commodities, and currencies. In essence, a CFD is an agreement between an investor and a CFD broker to exchange the difference in the value of an underlying asset between the time the contract opens and closes. Unlike traditional trading, CFD traders do not own the physical asset; instead, they speculate purely on its price movements. This makes contracts for difference a key instrument within the broader category of financial derivatives.

History and Origin

The concept behind contracts for difference emerged in London during the early 1990s. They were initially developed as a type of equity swap, traded on margin, by Brian Keelan and Jon Wood at UBS Warburg. The primary objective was to facilitate highly leveraged positions in the market without requiring physical ownership of the underlying shares, particularly for institutional clients involved in hedging activities. Their innovation offered a way to gain exposure to market movements while deferring or avoiding stamp duty in the UK, which was a tax on stock purchases.

Key Takeaways

• A contract for difference (CFD) allows traders to speculate on price movements of financial assets without owning the underlying asset.
• CFDs are leveraged products, meaning traders can control a large position with a relatively small initial deposit.
• Traders can profit from both rising and falling markets by taking long (buy) or short (sell) positions.
• CFDs are primarily traded over-the-counter (OTC) with brokers, rather than on regulated exchanges.
• Regulatory bodies in various jurisdictions have imposed restrictions on CFDs, particularly for retail investors, due to their inherent risks.¹⁹, ²⁰

Formula and Calculation

The profit or loss from a contract for difference is calculated based on the difference between the opening and closing prices of the underlying asset, multiplied by the number of CFD units traded.

The basic formula for calculating profit or loss (P/L) in a CFD trade is:

• (\text{Opening Price}): The price at which the CFD position was initiated.
• (\text{Closing Price}): The price at which the CFD position was closed.
• (\text{Number of Units}): The quantity of the underlying asset represented by the CFD contract.

Additionally, other costs may apply, such as the bid-ask spread (the difference between the buy and sell price) and overnight financing charges if positions are held for more than one day.

Interpreting the Contract for Difference

Interpreting a contract for difference primarily involves understanding the directional movement of the underlying asset's price and the impact of leverage. If a trader believes the price of an asset will increase, they would "buy" or go long on the CFD. Conversely, if they anticipate a price decrease, they would "sell" or go short selling the CFD. The contract's value reflects these price changes directly.

For example, if a trader buys a CFD on a stock at $100 and the stock price rises to $105, the trader profits from the $5 difference per unit. If the price falls to $95, the trader incurs a $5 loss per unit. The interpretation is straightforward: a positive difference between the closing and opening price for a long position (or a negative difference for a short position) indicates profit, and vice-versa for losses.

Hypothetical Example

Consider an investor, Sarah, who believes the price of Company X's stock, currently trading at $50 per share, will increase. She decides to open a long position on a contract for difference for 100 units of Company X. This means she effectively controls 100 shares without owning them directly.

1. Opening the Trade: Sarah buys 100 units of the Company X CFD at $50 per unit.
2. Market Movement: Company X announces strong earnings, and its stock price rises to $53 per share.
3. Closing the Trade: Sarah decides to close her position at $53 per unit.

Using the formula:
(\text{P/L} = (\text{Closing Price} - \text{Opening Price}) \times \text{Number of Units})
(\text{P/L} = ($53 - $50) \times 100)
(\text{P/L} = $3 \times 100)
(\text{P/L} = $300)

In this hypothetical scenario, Sarah would realize a profit of $300, excluding any commissions or financing charges. If the stock price had fallen to $47, Sarah would have incurred a loss of $300. This example highlights how CFDs allow for speculation on price movements without direct asset ownership.

Practical Applications

Contracts for difference find several practical applications in financial markets, predominantly in the realm of speculation and hedging. Traders utilize CFDs to:

• Gain Leveraged Exposure: CFDs allow investors to gain significant market exposure with a relatively small amount of capital through leverage. This means potential profits can be amplified, but so can losses.
• Access Diverse Markets: A single CFD trading account can offer access to a wide array of global financial instruments, including equities, commodities, indices, and foreign exchange, without needing to open separate accounts for each asset class.
• Profit from Falling Markets: CFDs simplify short selling, enabling traders to profit when they anticipate a decline in an asset's price. This can be used for speculative purposes or to hedge an existing physical portfolio against potential downturns.
• UK Energy Market: Beyond traditional financial trading, CFDs are also utilized in the energy sector. For instance, in the UK, Contracts for Difference are a key mechanism for supporting investment in low-carbon electricity generation. This scheme provides renewable energy generators with a stable "strike price" for their electricity, ensuring revenue certainty regardless of wholesale market price fluctuations. If the market price falls below the strike price, the generator receives a top-up payment; if it rises above, the generator pays back the difference, ultimately protecting consumers from high energy costs and incentivizing sustainable power development.,¹⁸

Limitations and Criticisms

Despite their flexibility, contracts for difference carry significant limitations and criticisms, particularly concerning retail investor protection. One of the primary concerns is the magnified risk due to leverage, which can lead to losses exceeding the initial deposit, although many regulated brokers now offer negative balance protection.¹⁷ Studies have shown a high percentage of retail clients lose money trading CFDs, with some analyses indicating that over 80% of clients experienced losses.,¹⁶

The over-the-counter nature of CFD trading means it is often less regulated than exchange-traded products, which can lead to concerns about transparency and counterparty risk. Regulatory bodies, such as the European Securities and Markets Authority (ESMA) and the UK's Financial Conduct Authority (FCA), have implemented stringent measures to curb the risks for retail investors. These include imposing leverage limits, mandating margin close-out rules, requiring negative balance protection, and enforcing standardized risk warnings.¹⁵,¹⁴ These regulations aim to mitigate the inherent market risk associated with these complex financial instruments.

Contract for difference vs. Futures Contracts

While both contracts for difference (CFDs) and futures contracts are financial derivatives that allow for speculation on the future price movements of an underlying asset, they have key distinctions.

The main confusion arises because both enable traders to take leveraged positions on various financial instruments without upfront physical ownership. However, futures contracts involve a binding obligation for future delivery or cash settlement by a specific date, making them more suitable for hedging by producers or consumers of commodities. CFDs, conversely, are purely speculative tools focused on the price difference, offering greater flexibility for short-term trading strategies due to their lack of expiration and smaller contract sizes, making them more accessible to individual traders⁷,,⁶.

FAQs

Are Contracts for Difference legal in the United States?

No, contracts for difference are generally prohibited for retail investors in the United States. Regulations like the Dodd-Frank Act require most derivatives, including CFDs, to be traded on regulated exchanges and cleared through central clearinghouses. As most CFD providers operate outside these environments, it effectively bans OTC CFD trading for U.S. retail clients.,⁵

What are the main risks of trading Contracts for Difference?

The primary risks associated with contracts for difference include magnified losses due to leverage, the potential for rapid price movements (market volatility), and counterparty risk since trades are conducted with a broker rather than on an exchange. Regulatory bodies often highlight that a significant percentage of retail accounts trading CFDs experience losses.,⁴

Can I lose more money than I deposit with a CFD?

Historically, it was possible to lose more than your initial deposit with a contract for difference due to leverage. However, many jurisdictions, including the EU and UK, have introduced "negative balance protection" as a regulatory requirement. This protection limits a retail investor's losses to the funds available in their trading account.³,²

How is leverage applied in CFD trading?

Leverage in contract for difference trading means you only need to deposit a small percentage of the total trade value (known as margin) to open a position. For example, with 30:1 leverage, a $1,000 margin deposit could control a $30,000 position. While this amplifies potential profits, it equally amplifies potential losses. Regulatory limits on leverage vary by asset class and region to protect investors.¹