Cfds
Family I · Instruments
Not to be confused with cfd.
CFDs are derivative contracts that pay the cash difference between the entry and exit price of an underlying instrument, such as a share, index, currency pair or commodity. The position is a contract with a counterparty rather than ownership of the asset, so no delivery or transfer of the underlying takes place. Because they are typically traded on margin, both gains and losses are magnified relative to the cash committed.
How a CFD position works
A CFD is opened at one price and closed at another; the difference is credited or debited in cash. A long position profits when the closing price exceeds the opening price, a short position profits when it falls. The underlying is never bought or sold, so there is no entitlement to dividends on a long share CFD or to voting rights, although a dividend adjustment is commonly applied to the cash balance.
Positions are usually funded with margin, meaning only a fraction of the notional exposure is deposited. The remainder is borrowed from the counterparty, and financing is charged on that amount, typically at a benchmark rate plus a spread for long positions and minus a spread for short positions. Margin requirements, financing rates and the treatment of dividends vary by broker, by instrument and by the jurisdiction in which the client is resident.
Worked example
The same arithmetic applies in reverse to a short position: a fall in the underlying produces a gain, a rise produces a loss. Financing charges accrue for each day the position is held and are not shown above.
Costs, margin and risk
- Spread — the difference between the bid and ask price quoted by the counterparty.
- Commission — charged on some instruments, often as a percentage of notional value.
- Financing — an overnight charge or credit on the leveraged portion of the position.
- Margin — the deposit required to hold the position; a margin call follows if the balance falls below the required level.
Leverage cuts both ways. A small adverse move in the underlying can consume a large share of the margin deposited, and losses can exceed the initial deposit where the counterparty does not offer negative balance protection. Whether such protection applies, and the maximum leverage permitted, depends on the regulator and the client classification.
Regulatory treatment
CFDs are restricted or banned for retail clients in some jurisdictions, notably the United States, while others permit them subject to leverage caps, mandatory risk warnings and negative balance protection. The counterparty is usually the broker itself, so the contract carries counterparty risk in addition to market risk. Tax treatment of gains and losses on CFDs also varies by country and by the residence of the trader.
Often confused with
- cfd
- A contract for difference (CFD) is a bilateral derivative agreement in which the seller pays the buyer the difference between the current value of an underlying asset and its value at contract time, or vice versa, without either party owning the underlying asset.