Contracts for Difference (CFD)

The emergence of new instruments in the international financial market also brings changes that inevitably affect both investors and brokers. Successful investments are impossible without the diversification of risks. Diversifying your risk is only possible through the allocation of funds and opening accounts in several brokerage firms that provide access to a variety of exchange and OTC markets. But a potential investor may face many difficulties, among which is the complex procedure of opening an account and the costs of information support and communications. The capital allocation does not always favorably affect the account balance. So, over time there may be marginal deficiency, when the money on an account is not enough to secure the volume of open positions. It is possible that an account with another brokerage firm will cover the occurred deficit, but the transfer of funds takes time and money.  

Thus, the basic requirements of an investor for the broker would be:

• maximum diversification of the account;
• minimum commission;
• low requirements for deposit.

An organizational solution for brokers to meet these requirements is to work with CFD.
The CFD is an attempt to transfer the rules of online forex trading market to exchange and OTC markets. The main advantage of the CFD is the access to different exchanges using a single brokerage account.

Of course, the CFD has its shortcomings. First of all, this is a speculative kind of trade. When using the CFD, you cannot expect a real delivery of the asset underlying the CFD. But this drawback does not cause serious difficulties for the bidders, since for most players the CFDs are interesting exactly as an instrument for speculative operations.

The main advantages of CFD:

• Minimum requirements for deposit. For almost all positions the deposit required is 5 -10% of the contract value;
• No need to wait for order confirmation on the exchange;
• The brokerage firm is actually a market maker for its customers, so is takes care of all problems;
• Guaranteed execution of the customer's stop orders, if there is any movement in the market. This is virtually impossible to achieve even when working on the exchange directly, since significant movements on the exchange trigger orders at prices unfavourable for investors.

Let us consider a small example to understand the CFD.

After carefully considering all fundamental and technical factors, a trader opens a long position and buys shares, the current price of which amounts to $10.35. The trader buys 1000 shares and pays a classical brokerage commission, which in this case is $10. Some time later, for example, when the shares price has risen to $10.85, the trader would be obliged to pay the specified commission. Thus, the profit of the trader will be as follows: (10.85-10.35)*1000 - 10*2 = $480. So, when in cooperation with a classic brokerage firm, you would need to raise funds in the amount of $5,180 and the return on investments would be only 9.3%.

If you resort to the CFD,  the profit from the transaction described in the example above would be the same $500 minus the commission, or $489.65, but in this case the trader uses the leverage of 10% and only needs to raise $1,035 of funds. So, the ROI of such transaction will be 47.3%.

In conclusion, we want to draw your attention to some important aspects:

• Above all, remember that CFD can not be considered as an absolute replacement of the classical exchange. It is more correct to consider a contract for difference as a great alternative to exchange market.
• You must understand that any exchange or OTC trading is a risky business, and the use of the CFD does not save you from those risks. Moreover, the CFD to some extent increases the risk of losing funds for a trader with a small deposit, if there are adverse changes in the market.
• The instrument of CFD, no doubt, would be interesting to many traders, who would use it in their trading activities.