A contract for difference (CFD) is, quite simply, the difference between where a trade is entered and exited. It can act as a tradable instrument, paralleling the movements of the underlying asset. Essentially, it’s a contract between the client and broker that allows traders the opportunity to turn a profit without actually owning the underlying stock.

In recent years, the popularity of CFDs has increased exponentially, largely due to the significant advantages attached to them.

Understanding How CFDs Work

The best way to explain CFDs is to use an example of how they work. Imagine that a stock has an ask price of $20. 100 shares are bought at this price, making the cost of the transaction $2,000. A traditional broker, levying a 50 per cent margin, would require traders to hand over at least $1,000.

CFD brokers are different. A typical margin for this type of broker is closer to 5 per cent. This would mean that a trader could affect their transaction by paying just $100.

The trade-off for this lower outlay lies in how profits are calculated. When a CFD trade is entered, the position shows a loss equal to the size of the spread. Thus, if the spread is 4 cents with the broker, the stock must appreciate 4 cents for the trader to breakeven. If the stock were owned outright, this same result would have equalled a 4-cent gain, although you would, of course, have been required to pay commission alongside having a larger capital outlay.

If the stock were to continue to appreciate, reaching a bid price of $20.50, traders with owned stock could sell it for a $50 gain ($50/$1,000=5 per cent profit).

The CFD trader, however, must exit the CFD trade at the bid price, and the spread is likely to be a little larger than in the actual stock market, which tends to reduce profits by a small amount. Irrespective, the proportional profit tends to be far greater. If we imagine that this difference pulls the gain down to around $48, this would result in a return on investment of an impressive 48 per cent.

It must be said that the CFD may, in reality, have been priced more highly than an ordinary stock at the outset. However, even if this caused the profit to drop by a further $2, to $46, this would still deliver a much greater profit than its alternative (46 per cent compared to 5 per cent), and the trader would not be liable for commissions or other fees.

Weighing It Up: The Advantages and Disadvantages of CFDs

If you’re considering adding CFDs to your portfolio, then it’s important to weigh up the many pros and cons before taking the leap. Here’s a brief outline to help you:

Advantages

• Higher leverage
• Global market access from one platform
• No shorting rules or borrowing stock
• Professional execution with no fees
• No day trading requirements
• A variety of trading options

Disadvantages

• There is no profit in small moves because traders have to pay the spread
• The profit in winning trades is eaten into by the spread
• The spread increases losses
• The CFD industry is not highly regulated, which means that brokers must be chosen with
• caution

Could CFD trading pose the perfect investment opportunity for you?