CFD (Contract For Difference) is still something relatively new in comparison with year-long speculation on the stock market. It was caught on by individual investors in a flash. And it is not a coincidence. These are very (if not the most) accessible and available derivatives.
What are derivatives? It is a kind of financial instrument which is not a security. The price of a derivative is dependent on the price of the base instrument on which it is based. These can be stock prices, bond yields, interest rates, stock indexes or many, many others, even so, exotic as the number of sunny days in a year or the amount of rain (these are so-called weather derivatives).
The reason for creating a derivative market was the need to secure from risk. However, later in pair with securing transactions – hedging – there were also clearly speculative transactions which then became “money printing machine”. They operate on the principle of taking on yourself risk connected with transaction, for this you expect receiving market premium – some measurable profit. What kind of profit? It depends on the size of the transaction, risk level, market volatility and many other things. Derivatives have the highest level of risk among all existing financial instruments. Profit (or loss) is additionally enhanced by financial leverage thanks to which the margin deposit for the transaction (the amount of capital we need to have to open transaction) is just a fraction of its price. Trading on derivatives let have many times bigger profit than trading on standard financial instruments on which they are based. We have to remember that in pair with multiplied profits there is also a possibility of multiplied losses.
In the end it is worth to add that transactions on derivatives can be opened both on organized platforms (for example futures contracts for WIG20 index from Warsaw Stock Exchange – FW20) and on not regulated markets – OTC markets (over the counter). Trading on OTC markets is offered mainly by Forex brokers, they also offer CFD on indexes, commodities or bonds.
CFD vs Futures
Construction of Contracts For Difference is in some point similar to the construction of futures contracts, however, there are some important differences between them. On the Forex market transactions are opened by current price (it is so-called spot market). What’s more, there is no expiration date of CFD what means that the moment of closing transaction is not set. Each transaction can be closed in any moment (of course during trading hours, depending on the contract kind it is trading hours of stock market session or trading 24 hours a day for 5 days a week like on Forex market). The possibility of a closing position in any moment is given by huge (without comparison to any other) volatility of the market.
Now we will take a look at other differences between futures and Contracts For Difference. The unit for futures is 1 contract which cannot be divided what means that you can open a minimum 1 contract (investors often use the name fut). In case of CFDs, the unit is 1 lot which can be divided to smaller parts such as 0.5 lots or less (most of the brokers have the lowest transaction unit of 0.01 lot which is called micro-lot or in some cases, 0.1 lots called a mini lot). Another difference is financial leverage which in the case of CFDs is much bigger – the most popular variant is 1:100, in case of futures it is no bigger than 1:50 and usually, it is even smaller. Financial leverage in both cases depends mainly on the intermediate party in trading – stock or Forex broker.
Another difference between futures and CFDs are swap points. These points are the difference between futures currency price and spot – current price. Technically speaking it is the difference between interest rates of different currencies. Depending on interest rates swap point can bring additional profit for the investor or become transaction cost. In the case of futures, there are no swap points because transaction price has a termination date. In case of Forex brokers swap is counted every day of keeping position and additionally (in most cases) once a week there is also a 3-days swap which counts swap for the weekend.
Another important issue is transaction costs. In the case of futures, the broker takes a commission for every opened contract. In case of FW20 commission – future contracts for Warsaw Stock – it is in the most case about 2€ for opening the contract and closing it. Sometimes there are time-limited lower offers. In case of CFDs, there is always a spread which is a difference between the current buy price and current sell price and rarely there is also additional commission (more often it is in case of CFDs for stocks than indexes).
The other is also the time of finishing contracts. In the case of futures, it is strictly set – usually 3 months. Usually, the day of finish is so-called three witches day which is third Friday of last month in the quarter – third Friday in March, June, September and December. In the case of CFDs, the expiration date is not set but usually, brokers do not let to keep the contract open for more than a year. There are some exceptions when we have some kind of combo CFD, for example, CFD for DAX30 futures. In this case, expiration of this CFD will come because it is based on DAX futures (not DAX cash index) and it also has their own series.
The last thing is the closing of the contract. Futures are closed by opening the opposite transaction. It means that when we have one buy contract on some instrument, to close it we need to open one sell contract. In case of CFD to close contract you just use “close” option.
Contracts For Difference trading is really interesting and (with proper skills) also the really profitable profession. CFDs are generally available because you can trade using investment account opened in Forex broker company. The paperwork is limited to the minimum, the whole process takes one day top and you can do it all on the Internet. In addition margin deposits are really low (it depends on broker offer) and that means you need a small amount of capital to start trading on CFDs. High leverage helps in getting big profits and low transaction costs (on respected brokers offers) are interesting for traders. On the other side, CFDs are one of the most volatile derivatives what means that trading on them is quite difficult and very risky. Don’t forget about that, especially if you are beginning trader. Remember to always test CFD on a demo account of a respected broker because every platform can offer different construction of CFDs and the different size of them.