By Adinah Brown

When I first began working in Forex, the term CFD seemed to have some magical properties as it could be applied to everything. As far as I could tell, corn was a CFD, and so was gold, oil, natural gas, and even some forex pairs, depending on who I asked.

But, when it was finally explained to me, things began to fall into place, and the importance of CFDs was clear, as was how to trade them.

CFD is an acronym that stands for “Contract For Difference”. It is a contract between a buyer and seller that has a time element associated with it. The term “difference” describes the difference between the value when the contract is opened, and when it is closed, at which time the buyer or seller will reimburse the other for this difference.

The contract is for an underlying instrument, so anything can be a CFD. The great advantage of a CFD is that there need be no physical exchange of items or shares which would attract capital gains or stamp duties or whatever local taxes are associated with the physical transfer of goods, services or ownership. As a result, it was first used as a derivative to provide exposure to hedge funds. Traders were able to own the value of the underlying asset without owning the actual asset, allowing them to offset their positions in a tax effective manner.

As a result of this flexibility, and its use as a hedge, CFD’s are widely available across all asset classes. It is possible to find CFD’s for forex, commodities, stocks, indices, ETFs, REITs,… basically anything that can be traded is available as a CFD.

It can be traded just like anything else on an exchange. So if you expect the underlying instrument to increase in value over the life of the contract, you would profit from a long position. If you believed that it will decrease in value, you should open a short position.

One of the more important things to bear in mind when trading a contract on an exchange is that the contracts have a finite life, and as a result, there might be different ways that the brokerage handles the end of a contract. Some brokerages allow the contract to run its full course, in which case the contract will close itself off, much like an option, at the close of the contract. Other brokerages undertake rollovers, where, for example, a corn contract with a close in August will be rolled over to a new contract for corn that has a close in October. Often this is done prior to the rollover date, so as to avoid the increase in volume and volatility that accompanies a contract as it comes closer to the close.

This second method is quite confusing for a trader, for 2 reasons. The first is that there is a significant difference between a ton of corn delivered in August and a ton of corn delivered in October (although not a ton of difference – sorry, I couldn’t help myself). Weather patterns, time of year and many other factors can impact supply and demand, which will impact the value of the underlying asset. This makes the new corn different in value from the old corn, and the value of the new contract will reflect as such. For those looking to cash in on their original contract, or ride out the later volatility for more profit, the rollover is not helpful.

The second reason is more about confusion on the part of the trader. Often the different life cycle stage of the new contact, as well as the value differences mentioned above, will mean that the price of the new contract is very different from the old contract. The broker adjusts the position by adding or subtracting the difference in swap, so if the profit decreases by $1000, this amount is added to the wap to ensure that no value is actually lost. However, understand this can be highly confusing for a trader who suddenly sees a profit of several thousand turn into a loss of several thousand overnight (or more likely the weekend), and really necessitates being forewarned.

CFD’s are a useful and exciting trading option, and if handled correctly, provide a wonderful opportunity for diversified trading. Remember the tricks and enjoy the experience.

About the Author:

Adinah Brown is a professional writer who has worked in a wide range of industry settings, including corporate industry, government and non-government organizations. Within many of these positions, Adinah has provided skilled marketing and advertising services and is currently the Content Manager at Leverate.