Analysis of Contract for Difference - Essay Example

 Meaning and History of CFDs

2.1 Introduction

This chapter aims at understanding the basics of CFDs. It will include a detailed meaning of what CFDs are, and will also include the history of the contract for difference. This will help provide a basis for the working of CFDs. Firstly the meaning of contract for difference is discussed, following which a detailed history of the financial instrument – CFD has been discussed.

2.2 Meaning of Contract for Difference

A contract for difference is also referred to as CFD. This is a contract that is entered into by a broker or a CFD company with its client or the trader. This agreement is normally where the two parties agree to exchange the difference between the price of the shares at the opening price and the price of the share at the closing for a particular trade. This can result in a profit or even a loss for the trader. Contracts for differences are normally traded on margins and these allow the traders to make profits even in the markets that are falling. Also, these financial instruments involve Spread Betting. This helps the traders make profits despite the changes in the markets. Even when markets are down or even if markets are rising, as here the traders do not take possession of the shares, i.e. they do not actually own the shares. This is one of the most commonly used financial tools and is very popular among investors as it allows for the traders to purchase the rights to buy or sell a contracted number of shares at a certain price for a pre-determined period of time from a given stock.

In short, CFDs can be defined as “A Contract designed to make a profit or avoid a loss by reference to movements in the price of an underlying item. The underlying item is not bought or sold itself. Similar to spread betting. Increasingly popular as an alternative to actual share trading as it allows margin deposit trading and legally avoids stamp duties or similar taxes. Typically, a Quoted CFD price will track the underlying share price quite closely”.

In these contracts, the traders can bet on the direction of a certain stock price and also decide the number of shares to be bet on based on this. If the bet is correct then the trader requires paying for the difference between the opening and closing price into the number of shares that have been contracted for. However, if the bet is incorrect then the trader requires paying the broker the difference.