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Contracts For Difference Risks And More Facts

Contracts for Difference, or CFD, are contracts between two parties, usually sellers and buyers, stating that buyers will have to pay sellers any difference between the current values of an asset and the value it had during contract time. Should the difference be negative, sellers pay up instead. Essentially, this makes Contracts for Difference financial derivatives that investors can take advantage of when prices are moving up or moving down on underlying financing instruments. Also applicable to equities, they are also often used in speculating markets.

Can you take advantage of Contracts for Difference everywhere?

CFD trading is initially available only in the United Kingdom, Poland, The Netherlands, Germany, Portugal, Italy, Switzerland, South Africa, Singapore, Australia, New Zealand, Canada, Sweden, France, Norway, Ireland, Spain, and Japan. Others will also follow suit but they are not allowed in the US due to restrictions on over-the-counter financial instruments set by the US Securities and Exchange Commission.

Trading CFDs

This product trading is done with a market maker or a broker called a CFD provider, whose job is to define contract terms, rates for margins, and which underlying instruments are to be traded. CFD providers fall into two different models, impacting the price of the traded instruments.

The market maker is the most common model, wherein the Contracts for Difference provider comes up with the pricing for the CFD and takes all the orders onto its very own book. Most CFD providers will work to hedge these positions according to their own risk models, which can be as simple as selling or buying the underlying or as diverse as consolidating client positions or portfolio hedges. On the other hand, the direct market access was made as a response to various concerns that pricing in the market maker model may not always match the underlying instrument. Physical trade on the underlying is guaranteed by a CFD provider to match each order made. However, the Contracts for Difference are still between the traders, with the provider and traders sill not owning underlying instruments.

Risks involved

Like most things in finance, this derivative also has risks. These include market risk, liquidation risk, and counterparty risk. The most common kind is market risk, where these are designed to pay off the difference between the closing price and the opening price of an underlying asset. Liquidation risk, on the other hand, lets CFD providers call upon parties to deposit additional money to cover additional variation margin, while counterparty risk is connected with the financial stability of a counterparty to Contracts for Difference.