Contracts for Difference (CFDs)

What are CFDs?

Contracts for Difference (CFDs) is an arrangement made between the trader and the broker where the trader can hold more positions over a certain stock at a lower cost but does not actually own the stock. CFDs allows traders to make more risky bets on the price movement of a stock while only paying a fraction of the cost. This is especially beneficial for traders who simply do not have enough funds to take on positions where they must pay the full amount for all the shares they wish to hold.

Example of a CFD:

Suppose you wish to purchase 4 shares of a company for a current price of $180 USD each. Normally, you would pay $720 USD total to purchase these stocks. With CFDs, you only have to pay 25% or $180 USD while the brokerage pays the difference of $540. Therefore, you now have the CFD position of $720 while only paying the fraction of the cost (assuming commission fees are excluded).

Suppose the stock’s current price rises to $200 USD. Your gain in the CFDs is equal to the amount of stock multiplied by the change in price. Therefore your gain will be 4 shares * $20 = $80 total profit. Because you used the $180 for the CFDs instead of purchasing 1 share (1 share * $20 = $20 profit), you made 4 times the amount of profit you would have made if you had bought the share only.

However, supposed that the stock’s current price fell to $130 USD. Your loss in the CFDs position will be 4 shares * -$50 = -$200 total loss. This loss exceeds the amount that you invested and may be deducted from cash that you currently have uninvested in your account. If you had purchased 1 share for $180, your loss would have been only $50 total.

Advantages of CFDs

  • Traders whose accounts have a net liquidation value under $25,000 are not subjected to the limitations of day trading rules (3 day trades only in 5 business days). Traders can buy/sell positions multiple times on the same day without being flagged as a pattern-day trader

  • Unlike options, CFDs do not have expiration dates, therefore the positions can be held indefinitely

  • Gains may be amplified since the users are trading on margin (borrowed funds)

Disadvantages of CFDs

  • Although CFDs can amplify gains, it also may magnify losses

  • Losses can exceed the amount of cash the trader has in their account and may subjected to a margin call (be asked to add more funds to their account). If the margin call is not completed, their position may be liquidated.

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