Contracts for difference are among the fastest growing financial trading instruments in the world. They are contracts between two parties, that is, a CFD provider and individual trader, based on the speculation of price movements on particular assets. Basically the CFD agreement involves the two parties agreeing to exchange the difference in value of an asset from the time the contract is formed to the time it closes. If the difference is positive, then the CFD provider pays the buyer/trader but if there is a negative difference, then the buyer loses his money. The margin that you put up is only to cover you should you make a loss during the trade. The margin is never more than 3% of the total value of the instrument. The CFD provider will cover the whole cost of buying the share instrument so as to hedge your position in that instrument.

CFD financing allows a trader/buyer to access financial instruments without actually owning them and to exploit their price movements. It is like trading in shares without having to actually own the shares. To be able to access these financial instruments, a buyer is supposed to put up a small amount of cash known as the margin. Trades are then conducted on leverage basis with margins ranging from 1% to 30% depending on the individual CFD provider. One advantage of this is that it exposes a buyer to control of larger positions without having to put up the full price of an instrument. This amplifies the potential for profit. Buyers use their small deposits and use it as a lever to borrow and gain access to a larger quantity of assets. With the margin requirements of CFD being low, you only need a small amount of money to take large positions in an instrument.

CFDs are generally traded over the counter with a broker or a market maker, known as the CFD provider. The CFD provider will define the contract terms of the margin rates and what underlying instruments it is willing to trade. They trade under two different modes which can have an effect on the price of the instrument traded. The first mode is the Market Maker (MM) which is the most common method. The CFD provider makes the price for all underlying instruments and hedge the positions based on their own risk model. The main impact of this method is that the price of the underlying instrument can be different from the market price allowing the CFD provider to be flexible in the products and the trading time it offers. The second mode is the Direct Market Access (DMA) which guarantees that the price of the underlying instrument is the same as the physical market price. This mode will only be employed by CFD providers provided that the underlying instrument can be readily bought and sold in the quantities that match the CFD and it is in most cases used for shares in CFDs. They are generally more expensive as the provider needs to cover the exchange transaction fees and he might not be able to get economies of scale by putting together client orders.

Anna Edgley is the author of this article on CFD Trading. Find more information on CFD here.