A contract for differences (CFD) is an agreement between an investor and a CFD broker to exchange the difference in the value of a financial product between the time the contract opens and closes.

Summary

• Essentially, investors can use CFDs to make bets about whether or not the price of the underlying asset or security will rise or fall.
• A CFD investor never actually owns the underlying asset but instead receives revenue based on the price change of that asset.
• Some advantages of CFDs include access to the underlying asset at a lower cost than buying the asset outright, ease of execution, and the ability to go long or short.
• A disadvantage of CFDs is the immediate decrease of the investor’s initial position, which is reduced by the size of the spread upon entering the CFD.
• Other CFD risks include weak industry regulation, potential lack of liquidity, and the need to maintain an adequate margin.

Underlying costs and fees

The costs of trading CFDs include a commission (in some cases), a financing cost (in certain situations), and the spread—the difference between the bid price (purchase price) and the offer price at the time you trade.

Advantages of CFDs

Higher Leverage

CFDs provide higher leverage than traditional trading. Essentially leverage multiplies your value of your trade.

<aside> 💡 Say you invest 100 dollars with leverage of 1:5, this means that your trade value is now 500 even though you only invested 100. If the share price increase by 10 dollars, your profit will be $50 dollars instead of $10. but this can also be said for your losses.

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Lower margin requirements mean less capital outlay for the trader and greater potential returns; however, increased leverage can also magnify a trader’s losses.

No Shorting Rules or Borrowing Stock

Certain markets have rules that prohibit shorting, require the trader to borrow the instrument before selling short, or have different margin requirements for short and long positions. CFD instruments can be shorted at any time without borrowing costs because the trader doesn’t own the underlying asset.

Disadvantages of CFDs

Traders Pay the Spread

Having to pay the spread on entries and exits eliminates the potential to profit from small moves.

The spread also decreases winning trades by a small amount compared to the underlying security and will increase losses by a small amount. So, while traditional markets expose the trader to fees, regulations, commissions, and higher capital requirements, CFDs trim traders’ profits through spread costs.