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What is a CFD?

What is a CFD and how does it work?

What does CFD stand for?

CFD stands for Contracts for Difference.

What is a CFD?

They are similar to the normal purchase of shares/investments, however rather than having to pay for the investment outright, you are lent a significant portion of the investment by the CFD provider (in a similar way to spread betting).

CFDs are often used to hedge existing positions and according to some sources trading in CFDs for hedging account for circa 30% of trading volumes on the LSE. Due to its hedging capabilities the CFD market probable most resembles the futures and options markets.

How does a CFD work?

As usual, this is best explained with an example (ignoring commissions for now):

You have £500, and want to speculate on an individual stock trading at £50.

If you were to purchase these shares outright, you would be given 10 shares. If the share price goes up to £55, your investment is worth £550 (10 shares x £55), leaving you with a profit of £50.

If you purchase a CFD, you only required to invest an initial margin (usually between 10% and 20% of the value of the underlying shares. So in the example above, if the margin is 10%, you would be able to purchase £5,000 worth of shares (i.e. 100 shares) rather than just 10. Now if the share price rises to £55, then your holding is now worth £5,500 from a £500 investment – which is a 100% return. Bear in mind that things can go in the other direction, so you could lose the same amount if the share price goes the other way.

At the time of writing, CFDs aren’t allowed in the US due to SEC (securities and exchange commission) regulations.

For the more visual among you, here is a video that explains in further detail:

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