A CFD is a contract between two parties, the buyer and seller, which stipulates that the seller will pay the buyer the difference between the current value of an asset or index and its value at a later time if the value has increased at the point the contract was closed.
Whenever the acronym CFD is mentioned, there’s potentially a thousand and one combinations that may run through your head.
Here are a few odd ones: Call For Discussion, Car Free Day, Chinese Fire Drill, Cubic Feet per Day, Child and Family Development and Compulsive Forwarding Disorder.
I must admit, the latter is most hilarious. But a not-so-new addition to this long list is Contract For Differences. Today’s article is about these tradable instruments.
What are CFDs? A CFD is a contract between two parties, the buyer and seller, which stipulates that the seller will pay the buyer the difference between the current value of an asset or index and its value at a later time if the value has increased at the point the contract was closed.
Conversely, if the value falls, the buyer will pay the seller the difference. Let's give an example. If you buy 100 CFDs on KCB at a price of Sh44.5 with a 20 percent margin, your initial outlay will be Sh890 (Sh44.5 buy price x 100 shares x 20 percent margin).
If the value of KCB stock moves to 50, and you decide to sell at this value — a 5.5 point increase, the profit you will make is Sh550 (5.5 point increase x 100 shares = Sh550).
In this way, CFDs represent financial derivatives which allow traders to acquire exposure without any need to own the underlying asset. In fact, they provide similar economic benefits to an investment but avoid certain costs and complexities associated with physical ownership.
But let’s rewind a little, speculating with leverage on the financial markets was never a retail affair. Trading on margin was limited to futures or options on derivatives exchanges out of reach for the retail masses.
However, with the emergence of CFDs and online trading platforms, retail customers are now able to easily trade on margin and gain exposure to a wide range of global financial markets and instruments (Indices, Stocks, Currencies, Commodities).
To date, the CFD market is now served by a number of large-to-small scale players including, for example, IG, CMC, Ingot Brokers, Scope Markets, EGM, Plus500 and Saxo, just to name a few.
Note that these instruments are highly speculative and trades are usually not made on any exchange — there are no clearinghouses for CFDs.
A major differentiating factor is that most brokers will not charge a commission but a spread — that is, the price to buy will always be higher than the current underlying value and the sell price will always be lower. The difference between these prices is called the CFD spread.
Why use them? Not only is one able to trade on margin, CFDs offer a cost-effective access to trade on a wide range of global financial markets. One may also elect to go short or to go long. Additionally, CFDs can be used to hedge an existing portfolio besides letting the client deal when the underlying market is closed.
In sum, CFDs are a welcome addition to the world of markets. And next time your broker utters the word, now you know it doesn’t stand for Chinese Fighting Ducks.
