What Is Contract For Difference?

What is contract for difference or what is a CFD when it comes to trading?

While there is a formal definition at wikipedia (CFD wiki on Contract for Difference), a more informal definition of a CFD in trading is that when you buy a CFD on a stock, index or commodity, you profit from a rise in the stock, index or commodity price without formally owning the underlying stock, index or commodity.

You do not officially own the underlying stock, but instead are dealing with a market maker.

History of Contract for Difference

Contract for difference was originally developed in the UK, in the 1990s and were traded on margin and did not attract stamp duty, for institutional investors to hedge positions, and were eventually offered to retail investors.

With market makers the spread between the bid and ask may be different to that of the underlying stock.

Some CFD providers offer DMA or direct market access CFDs where the prices and spread do match that of the underlying market, but their commissions may differ to those of market maker CFDs.

Contracts for Difference After The GFC

During the global financial crisis or GFC of 2007-2008, there were bans on short trading with stocks and many CFD providers felt the pressure to follow suit as well.

These were unusual circumstances and there is a possibility that it may happen again in future.

The main trends in CFD trading now after 2011 are:

1. More responsible us of leverage.

In markets that are changing, it is recognised that high leverage usually means high risk.

Many traders are now more aware of the pros and cons of leverage and are choosing to use a more modest level of leverage that is available. While leverage is available, it doesn't mean that you have to use all of it.

Similarly, many providers have a range of margin required for CFDs up to 80-100% for some CFDs.

2. More regulation of the CFD provider industry.

As governments realise the popularity of certain trading products, regulation of CFD brokers refers to guidelines for the practices and standards of these companies in terms of their levels of disclosure of information about financial products, their practices, their privacy policies, etc.

This also correlated to people being more aware of the need to check out their provider as well.

This means that transparency goes both ways, with consumers being more aware and asking more questions and providers disclosing more information.

3. More types of CFD products.

There are a new type of CFD recently introduced to some markets, called Exchange Traded CFDs, which are CFD products provided by the ASX.

As mentioned there are DMA and market maker CFDs as well.

There are differences between these types of CFDs that you should know about which can affect your trading, not just with the differing commissions and brokerage, but also the way in which liquidity and spreads are handled.

You can find out more about these types of Contracts for Differences or CFDs here.


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