Contract for Difference Explained

Definition: A contract for difference CFD is a contract which enables you to buy or sell a share in the future. Unlike futures they don’t necessarily have a fixed date for completion.

Essentially Contract for difference (CFDs) are used as a way for people to try and make money from predicting future share movements.

  • If you expect share prices in a company to rise, you take a long position. This means you would take a contract to buy shares at todays price in the future.
  • If you expect share prices in a company to fall, you take a short position. This means you would take a contract to sell prices at todays price in the future.

Example of Contract for Difference

For example, suppose shares in ICI are trading at 500p.

  • A CFD with a long position means you could agree to buy 1000 shares in the future at £5. (cost = £5,000)
  • CFDs usually require only a deposit of 10 – 20%. Therefore, your initial payment could be just 10% of £5,000 = £500
  • If the share price of ICI rises, you will make a good profit. Suppose the price rises to £9.
  • This means your CFD is now worth (£9-5) £4 * 1000 = £4,000. This is from an initial deposit of just £500.

If you had bought regular shares, your investment would have gone from £500 to just £900.

CFDs and Trading on the Margin

Because CFDs allow trading on the margin, your profit and losses can be magnified.

For example, suppose the shares of ICI fell from £5 to £4. You are sitting on a loss of £1 *£1,000. Therefore when the contract ends you would have to pay £1,000 in addition to the £500 deposit.

Why CFDs became Popular

CFDs became popular in the 1990s and 2000s. They are an example of how financial institutions are clever at developing new products to get around regulation and tax.

  • It was away to trade in shares and avoid paying stamp duty.
  • It is easier to influence share prices anonymously. e.g. if you take a big stake in a company, you are known. But, if you buy long CFDs to boost a share price, it is harder for markets to find out who you are.
  • You can benefit from share price movements without owning any shares.
  • They could be useful for people with insider information that share prices were set to fall. Though this is illegal it can be difficult to spot.
  • They allow trading on the margin and so can magnify profits. This was attractive to hedge fund managers who gained big bonuses for making spectacular gains but were more immune if they made large losses.

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By on March 30th, 2009

One thought on “Contract for Difference Explained

  1. Is there a time limit?

    With the example of ICI share price rising can it be cashed in if the buyer of the CFD decides to sell if they feel the price has reached its possible limit or does the buyer have to wait until a certain time?

    In another way if ICI share price fell can the CFD be sold before too much loss accumulates?

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