Contract for Differences: Definition
A contract for differences involves an arrangement concerning financial derivative trading where the differences in the settlement between closing and opening trade prices are cash settled. CDFs do not include the physical delivery of securities or goods. This is an advanced trading strategy commonly utilized by highly experienced CFD trading Equiti traders.
Initially, contracts for differences were used in exchange–traded futures on both interest rate contracts and stock indices. They were suitable for these instruments as those involved in financial futures either did not want or need to receive or make delivery of the underlying instruments in their trading.
Understanding Contract for Differences
Typically, CDFs allow traders to trade in the price movement of derivatives and securities. Derivatives involve financial investments derived from a particular underlying asset. Usually, contracts for differences will be used by investors to make price bets on whether the price of an underlying security or asset will fall or rise. Thus, a CDF trader can either bet on the downward or upward price. Those forecasting a downward shift in the price will sell an opening position, while those predicting an upward shift will buy the CDF.
Further, if a buyer of a CDF achieves a price rise of the asset, they will offer their holding for sale. And the net difference between the sale and purchase price will be netted together. The net difference showing the loss or gain from the trades is usually settled through the investor's brokerage account.
On the other hand, if a trader predicts that a security’s price will go down, they can place an opening sell position. They must buy an offsetting trade if they want to close the position and their net difference of the loss or gain settled through their account in cash.
What is Involved in Transacting CDFs?
CDFs can be used to trade numerous securities and assets, such as exchange-traded funds(ETFs). Traders can also use these products to guess the price shifts in commodity futures contracts like corn and crude oil. Future contracts involve standardized contracts or agreements with obligations to sell or buy a specific asset at a current price but with a future expiration date.
While contracts for differences allow investors to trade the price shifts of futures, they are not future contracts themselves. They lack expiration dates having current prices. Nevertheless, they trade like other securities with sell-and-buy prices. CDFs trade over the counter through a network of brokers who organize the market supply and demand and make prices for CDFs accordingly. In simpler terms, contracts for differences are not traded on significant exchanges like the New York Stock Exchange. Therefore, a CDF involves a tradable contract between a broker and a client exchanging the difference between the initial price of a trade and its value after the trade is reversed or unwound.
Why Should You Trade With CDFs?
Primarily, contracts for differences will offer traders all the benefits of owning a security without actually taking any physical delivery of the asset or owning it.
Additionally, CDFs are traded on margins. This means that the broker allows investors to borrow cash to elevate the leverage or size of the position, thus amplifying gains. However, you will be required to maintain a specific account balance before being allowed to access such transaction types. Trading CDFs on margin also offers increased leverage, unlike traditional trading.
You will enjoy fewer rules and regulations surrounding the CDF market than those in standard exchanges. For this reason, contracts for differences can have reduced capital or cash requirements in a brokerage account. You can have an account for as low as 1000 dollars with a broker.
Again, contracts for differences enable investors to take short or long positions easily or even sell or buy positions. Remember that the CDF market lacks short-term selling rules, meaning an instrument could be shortened at any time.