Contract For Differences (CFD) – Chapter 1: An Introduction to CFD’s
During the last four years, Contract For Differences (CFD) has become a favorite investment vehicle for private investors after their debut in the retail financial market. Many of these private investors have resorted to this innovative financial vehicle to seek financial freedom.
CFDs first entered the retail financial market in 1998, a decade after becoming recognized as a viable replacement to the traditional share market among the big players in the financial markets. The impetus behind its growth was due to the high stamp duties imposed by the UK Government and the problems associated with sustaining a short term position in the equity market of different shares. CFDs as an investment vehicle are excellent for a short term position in the market. Nevertheless, they cannot act as a long term investment vehicle like ISAs can or self funded pension schemes. But as an investment vehicle for the short term, they are equal to none.
What CFDs are:
CFDs are actually contracts between two consenting parties; the CFD company or brokerage firm and its client, the trader. In the contract, the trader has to settle at the expiration of the CFD the difference between the opening and closing price of the contract times by the quantity of shares specified in the contract. In other words, it is a contract to substitute the differences between the opening share price and the closing share price at the end of a particular trade. The result could either be a gain or a loss for the investor.
The way that they are traded is almost the same way as equities. Investors can also trade them on a margin like spread betting and gains can be realized form the bear or bull’s market because the legal title of shares traded in does not belong to the investors. The beauty about CFDs is that they allow investors to use it as a financial tool to obtain the “rights” to purchase or dispose of a specified quantity of shares in a specified stock at a fixed price at a specified date.
The similarities between CFDs and equity trading are quite striking. You are able to purchase CFDs at the underlying market price and the volume with which you trade in is as if you are trading with equities. As with the equity market, you will be charged a commission for the transactions executed. The commission payable is based on the quantity of shares traded multiplied by the prevailing market price. Nevertheless, there are specific differences between these two markets which will be seen in the next chapter.