A Contract for Difference (CFD) is a form of derivative. It is a contract or agreement between an investor and the CFD provider, who is usually a stockbroker. The contract entered into concerns the future direction of a share price or the value of a financial asset. A CFD’s performance is based on (or derived from) the movement of the price of an underlying asset, which does not have to be bought or sold.
CFD Example:
An investor enters into a CFD contract with a broker on 1,000 ABC Ltd shares with a total market value of £20,000 (i.e. 10,000 shares x 200p per share) at the date of the contract issue The CFD terms state that if the share price in ABC Ltd rises the broker will pay (in cash) the difference between the share price set in the contract (the ‘strike’ price) and the price at which the investor chooses to close-out the CFD (close down).
Rather than buying the physical shares now in order to realise a later gain by selling the shares when the price has risen, the investor benefits from the movement in the share price without ever physically owning the underlying shares.
Equally, as an investor can make a judgement on the direction the underlying share price will move, the investor can make profit when the share price falls as well as rises.
By entering into a CFD contract the investor is effectively placing a monetary bet on the direction in which a company’s share price will move. The bet can be placed on an exchange listed company’s share price or a market sector (such as the FTSE 100 index).
CFDs are dealt on a margin basis. This means that when entering into a CFD transaction the holder pays a ‘margin’ (i.e. a deposit), which is typically around 10% of the contract value, to the CFD issuer. So in the above example with a CFD valued at £20,000, the margin required will be £2,000.
In undertaking any CFD transaction, the CFD holder must be able to cover the entire contract value and any associated costs if the price moves unfavourably.
CFD holders are also required to maintain a minimum deposit/margin level in their account with the CFD issuer. Therefore if their CFD investments have performed poorly, which will eat into the margin, they may be required to top up their margin to ensure it remains at the required level.
See STSM118020 for fuller information on how a CFD operates.
