According to Saxo bank, a contract for differences is a swap agreement under which two parties exchange cash flows based on whether the price of an underlying asset goes up or down within a predefined period.
Commonly abbreviated “CFD” is a tradable financial derivative that allows traders to speculate on the change in the value of a particular market instrument.
A contract for difference is used to speculate on underlying assets such as stocks, commodities and currencies without actually owning them.
Long or Short positions
If an investor enters a CFD agreement, then they are “long” or “short”.
A long position would occur if you bought the asset expecting its value to go up so you could sell it at a higher price than what you initially paid.
If the opposite were true and an investor sold an asset, he expected to decrease in value to purchase it back at a lower cost; then it is a short position.
The long position party agrees to pay the counterparty any gain from selling the asset for more than the original purchase, minus any losses incurred when buying back at a lower price.
The party with the short position agrees to pay to the counterparty any loss suffered when selling an asset at a lower price than the original purchase, plus any gains made from a subsequent buyback at a higher cost.
Lawyers and legal experts said that if BTC China’s closure goes forward, it could create “a panic” among investors who would be forced to close their positions before their contracts expire, possibly resulting in major losses.
There are certain things that differentiate a CFD from an actual purchase. A difference exists between cash-settled CFDs and physical settled ones.
Cash settled contracts require no physical delivery amounting to nothing more than a change in the account balance. The cash amount changes according to the movement of the underlying security.
For example, if a trader buys shares for $100 and sells them for $120, they will receive $20. Additionally,cash-settled CFDs allow traders to make a profit on both rising and falling markets.
Advantages of CFDs
There are both advantages and disadvantages to a contract for differences. The major advantage is that we consider it as an off-balance sheet item.
Since futures contracts are all considered balance sheet items, there is no need for capital requirements with a contract for differences because it does not change the assets or liabilities in a company’s books.
Another benefit is that there will be no margin calls, meaning a party can limit their potential losses by choosing how much they wish to risk per trade.
With futures, they have to put up a certain amount of money based on what type of position they have, whether long or short, so there can be considerable risks involved, especially if you open up several positions at once and the market moves against you.
Disadvantages of CFDs
A disadvantage of a contract for differences is that there are no futures price limits to protect the parties with standard futures contracts.
It means you could face unlimited potential gains and losses, depending on the market activity.
Another downside is that CFDs will expose an investor to leverage risk.
Suppose an investor has some type of negative sentiment about a particular stock or commodity. In that case, they may opt to purchase some put option, which would mean if the price dropped below a certain level during a predetermined period, you would make money on it; if not, then you would limit your loss to what you paid for it upfront.
A CFD is used as either a spread betting instrument or traded on margin trading similar to futures.
As with any agreement, it is essential to carefully review the terms and conditions of such a contract before entering it.
If you find yourself in such a situation, make sure you understand what an independent financial adviser can do for you. If needed, seek professional legal counsel to ensure that everything goes according to plan and that both parties are on the same page.