What is CFDs?

Contract for differences (CFD) is a financial contract where profit-and-loss is the direct differences between the open and closed prices of an underlying. The underlying of CFDs could be a stock, currency exchange rate, market index, future or other derivatives contract. CFDs are usually settled in cash. There is no physical delivery of goods or securities.

As CFDs only pays the price differences between the open and closed trades, it essentially allow investors to trade the direction of securities for short-term speculating, which are especially popular in FX and commodities markets.

How to trade CFDs?

CFDs allow investors to trade in the price movement of securities. In other words, CFD traders may bet on the price moving up or down. Traders who expect an upward movement in price will open a CFD buy contract, while those expecting a downward movement will open a CFD sell contract.

The net difference between the purchase price and the sale price are netted together. The net difference representing the gain or loss from the trades is settled through the investor's brokerage account. Conversely, if a trader believes a security's price will decline, an opening sell position can be placed. To close the position they must purchase an offsetting trade. Again, the net difference of the gain or loss is cash-settled through their account.

Mathematically speaking, the profit-and-loss is calculated as:

Understanding CFDs

If readers have some basic knowledge about forward, you should realise that the payoff diagrams for CFD look similar to that of a forward contract. In fact, they are similar but not exactly:

Benefits of CFDs

• There are no short selling restrictions. It is feasible for investors to enter into either a long or short position.
• A CFD brokerage account usually cover CFD products of a wide range of underlying financial markets. It allow investors to trade the price movement of multi-asset class such as ETFs, FX, stock indices, and commodity futures.
• Investors can receive the potential return without actually owning the underlying asset.
• It can be traded with margin which can magnify the potential profits/loss.
• As an OTC product, there are fewer regulation compared to standard exchanges. Thus, it has a lower deposit requirement (eg. US1,000) for opening a CFD brokerage account.

Disadvantages of CFDs

• CFD trading usually involve leverage which can manify both potential profits and losses.
• If the underlying experiences extreme price fluctuations, brokers might
  • increase the margin requirement for opening a new trade
  • widen the bid ask spread for risk management and to protect their own position
• As CFD is traded over-the-counter which is not highly regulated, traders are reliant on a broker's reputation and credibility.

Examples

Suppose our brokerage account use HKD as the base currency. We also open a long position of 1 contract for S&P500 Index CFD (SPXUSD) at US$2700 with leverage 50:1, where the exchange rate for USDHKD at that time is 7.781. Also, the contract size for SPXUSD is 100. Then, for opening such an order, the margin amount will be

It means that in our brokerage account, we should have at least HK$42,017.4 available cash balance in order to open such an order. Otherwise, the order will be rejected.

On the other hand, suppose we close the position when SPXUSD rises to US$2750 in the meantime USDHKD becomes 7.782. The profit-and-loss will then be calculated as

Conclusions

CFD trading would be a good choice for

• beginner who only has a small deposit to get start
• experienced investors who want leverage and to trade on both buy/sell direction

On the other hand, due to OTC clearing and leverage features, it is also important to

• choose a reputable CFD broker to reduce the counterparty risk.
• manage your capital properly, and never over utilize the margin