Contract For Difference

Updated on April 4, 2024
Article byNanditha Saravanakumar
Edited byNanditha Saravanakumar
Reviewed byDheeraj Vaidya, CFA, FRM

What Is A Contract For Difference (CFD)?

A contract for difference (CFD) is  financial contract  between buyer and seller to exchange the difference between the prices on opening and closing dates of an underlying asset, index, or commodity in the derivatives market. The purpose of this contract is to allow parties to exchange the difference in the price without actually owning the asset.

Contract for Difference Meaning

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So, if the price rises, the seller (holding a short position) has to pay the difference amount to the buyer (holding a long position), and if the price falls, the latter will pay the former. Further, retail investors in the United States cannot trade in CFDs. However, these also carry risks such as high leverage, potential for loss, and lack of regulation in some jurisdictions.

Key Takeaways

  • Contract for difference refers to the financial derivate in which a buyer, who goes long, and a seller, going short, enter into a legally binding arrangement. 
  • The winning party will receive a payment equal to the difference between the opening date and closing date prices. Thus, if there is a price hike, the seller pays the buyer; if there is a price fall, the buyer pays the seller.
  • CFDs are available for a variety of financial instruments, including stocks, bonds, currencies, financial indices, and commodities such as gold and oil.
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Contract For Difference Explained

Contract for difference is an advanced financial tool mostly adopted by experienced investors. Acquiring a thorough understanding of the highly complex and technical concepts behind CFDs requires extensive practice, and it is essential for traders to do so. So let’s simplify the idea.

Like in any financial derivative, the investor doesn’t hold an asset (stock, bond, etc.,) but they trade on the price movements of the asset. So, a buyer predicts that the asset or index price will increase, and a seller predicts that the price will fall. As of the closing date, the one who makes the correct prediction will profit. Therefore, let’s understand how a financial contract for difference works:

  • A trader decides to buy or sell these contracts for an underlying asset, such as a stock currency or commodity.
  • Then, the trader selects the amount of the contract they want to buy or sell and the opening price.
  • Therefore, at the end of the trading period, the trader will close the contract by selling it to the market.

Also, another important concept related to CFDs is leverage. Brokers offer leverage to investors that help finance the latter’s investments. With this, investors can pay a small portion of the investment cost as a margin, and the broker will pay the rest. Of course, how much leverage the broker offers depends on the investment and the investor’s portfolio, and past performance. Hence, it is essential that both parties carefully review the contract for difference agreements before entering into the transaction.

Examples

Let us understand the concept better with the help of examples.

Example #1

Let’s assume a trader believes that Coupang Inc company stock price will increase shortly. Thus, the trader contacts their brokers and opens a contract for 100 shares of the company’s stock at an opening price of $50. To this, the trader puts a margin of 10%, or $500, to cover potential losses. Hence, if the price of the company’s stock rises to $55 per share, the trader will close the contract and make a profit of $500 ($55- $50 x 100 shares). However, if the price of Coupang Inc stock falls to $45 per share, the trader will close the contract and lose $500 ($45- $50 x 100 shares).

Therefore, in this example of a contract for difference, the trader has profited from the increase in the price of the company’s stock without actually owning the shares. Moreover, the trader has also been able to control a prominent position in the market. 

Example #2

Absolute Markets Insights’ Global Contract for Difference, CFDs Market Report, provides an in-depth study of the worldwide market’s current and future scenario, industry revenue, and growth status. Moreover, the report discusses market growth factors such as size, share, demand, industry trends, growth, and opportunities.

According to the report, the global contract for difference (CFD) market is expected to reach $7647.60 million by 2030, expanding at a CAGR of 3.10% between 2023 and 2030.

As a result, the report discusses key trends in the CFD market as well as growth strategies that are both inorganic and organic. Several businesses concentrate on natural expansion methods such as product launches and approvals, as well as others such as trademarks and events. Inorganic growth strategies observed in the market included deals, alliances, and cooperation. These activities have also made it easier for market participants to expand their business and customer base.

Tax Treatment

The tax treatment for these contracts varies depending on the country and the specific tax laws and applicable regulations. The Internal Revenue Service (IRS) rules and regulations govern the tax treatment of CFDs in the United States. Profits earned from trading CFDs are generally treated as capital gains or losses for tax purposes in the United States.

Besides, if a trader holds the contract for difference agreement for more than a year before selling it, any profits gain are considered as long–term capital gains and are subject to a lower tax rate. In contrast, if held for less than a year, profits are regarded as short-term capital gains and are subject to traders’ ordinary income tax rate.

Moreover, any losses from this contract can offset gains from investments up to $30,000 per year. In addition, traders should consult with a qualified tax professional to ensure they are up-to-date with the latest tax and regulations for contracts for different trading in the United States.

Advantages And Disadvantages

Now, let’s weigh the upsides and downsides of contracts for difference trading.

Advantages

  • One of the most significant merits of investing in CFDs is that the traders do not have to worry about the physical ownership of the asset or the index. Thus, they are not entitled to any additional responsibility with the instrument.
  • Leverage is another important factor in trading CFDs. Leverage allows investors to invest without spending money entirely out of pocket. So they can still profit without investing thousands of dollars themselves. Leverage is commonly known for its ability to magnify returns. Some brokers even offer a 1% margin.
  • Also, unlike options trading, there is no specified minimum number of contracts that the investor should hold. A trader can buy or sell a single of these contracts, which provides ample time for investors to study the instrument before investing heavily.
  • CFDs have a lot of flexibility in that they can be traded 24 hours. Moreover, few regulations surround CFD trading. In addition, the brokerage fees and cost is also considerably lesser.
  • Finally, unlike other financial investments in which traders benefit only from price increases (stocks, bonds, etc.), CFDs traders can benefit from increases and decreases.

Disadvantages

  • Leverage makes CFDs highly disadvantageous. Since it magnifies profits, it can also magnify losses to the same extent.
  • When investors incur losses, they will have an additional liability toward their broker. However, this comes with daily interest on the borrowed amount.
  • CFDs are as prone to market volatility and fluctuations as any other financial instrument.
  • Investors can become vulnerable to fraud precisely because these markets are not highly regulated.

Contract For Difference vs Swap vs Futures

Let’s understand the difference between CFD’s swaps and futures.

  • CFDs, swaps, and futures differ in what is being exchanged between the parties. Hence these contract exchanges the difference between the opening and closing price of an underlying asset, swaps contracts exchanges cash flows based on the predetermined interest rate and currency exchange rate, and futures exchanges an underlying asset at a future date.
  • CFDs are settled in cash, while swaps can be settled in cash or through physical delivery of the underlying asset. Futures contracts can also be settled in cash or through physical delivery.
  • Futures contracts are typically traded on an exchange, while CFDs and swaps are often traded over the counter (OTC).
  • Swaps and CFDs do not have a fixed contract size, whereas futures contracts have a fixed size.
  • Thus, CFDs are primarily used for speculative trading, and in contrast, swaps are mainly used for hedging interest rates or currency risks. Futures can be used for both speculation and hedging.
  • Moreover, these contracts and swaps do not have a fixed expiry date, while futures contracts have an expiry date.

Frequently Asked Questions (FAQs)

1. Why are contracts for difference banned in the US?

These contracts are not necessarily banned in the US but are highly regulated and restricted. They are regulated for the following reasons:
– Since these contracts are considered to be high-risk financial instruments.
– And there is concern that inexperienced retail investors could suffer significant losses.

2. Is the contract for difference trading suitable for beginners?

These contracts can be risky and are generally not recommended for beginners. In addition, since trading these contracts requires a certain level of knowledge and experience, beginners may find CFD’s trading overwhelming and might need help to make informed trading decisions. Hence, this form of trading can offer potential opportunities for experienced traders; it is generally not recommended for beginners. Thus, novice investors should build a solid foundation of knowledge and experience before they consider trading CFDs.

3. How does a contract for difference broker make money?

The contract for difference brokers makes money primarily by charging fees and spreads. Here are a few common ways that CFD’s brokers make money:
– Spreads
– Commission
– Overnight fees
– Inactivity fees
– Hedging

This article has been a guide to what is Contract For Difference. Here, we explain its examples, comparison with swap and futures, tax treatment, and advantages. You may also find some useful articles here –

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