CFDs, or Contracts for Difference, are vehicles through which traders are able to speculate on the future movements of the financial markets. They are often lost in the wider financial jargon, simply because most people are able to recognise “Forex”, or “Commodities”, or “Bonds”, or “Shares”, or any other specific asset class which are commonly traded across the globe, but most people would not be familiar with any asset class known as “CFDs”.
Perhaps to compound the confusion, when an explanation is sought over what exactly a CFD is, the answer is typically “A CFD is a derivative”. This does not lend itself to being a complete answer. So let us now try to explain exactly what is a Contract for Difference, by first explaining a derivative.
We will begin by breaking down the word itself – “Derivative”… “derived from something”. So a derivative is an instrument whose value is derived from something else. When we are involved in online trading, we do not buy any physical asset. We do not sell any physical asset. What we do is much simpler – we speculate.
When we speculate, we analyse a market (hopefully using a proven trading strategy), and we decide whether that market has a higher chance of rising or falling. If we believe that it will rise, then we enter a trade where we speculate a set amount of capital per pip (point / tick) e.g. $0.10/pip, that the market will indeed rise. If that is the result, then we earn (in this example) $0.10/pip as the market moves in our favour. If we get it wrong – if we speculate that the market will rise, but it actually falls – then we will lose (in this example) $0.10/pip as the market moves against us.
It is this speculatory event, coupled with leverage, which has led the US Government to consider trading CFDs as a form of gambling and subsequently (and somewhat contradictorily) banned the citizens of what is popularly described as the fortress of democracy and freedom from trading the CFD market.
This speculation process is a way of trading the underlying market. Imagine that we were hoping to speculate on the future movements of Facebook, Inc. Facebook, Inc. is currently trading at $109.62 per share. If we believe that Facebook, Inc. will continue to rise, then we speculate by entering the market to the long side. (We will discuss going long and going short later in this blog.)
However, we do not buy shares in Facebook, Inc. If we did, we would have to get in touch with our high street wealth manager / broker and we would eventually be sent physical share certificates in the mail a few days / weeks later. Typically, this is not what a modern day trader is looking for. The modern day trader wants to enter, exit and realise a gain as quickly as possible – so instead of contacting a wealth manager / broker, they open an account with an online brokerage.
This online brokerage will normally provide a wide range of markets – certainly a listing of the top several hundred most popular – and they will provide a price which should be a perfectly accurate representation of the price of the physical market. This representation is derived from the physical market price i.e. it is a derivative.
It is, therefore, the access to this derivative of the market price, which allows us to speculate on broader CFD market.