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 »  Finance

Understanding How CFD Financing Works

By: Anna Edgley

Date Added : June 21, 2011 Views : 1509
Rate Author : Current : 2.79 /5
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Contract of difference or CFD is an agreement between two parties normally a seller and a buyer where the buyer agrees to pay to the seller the difference in value of a particular financial instrument between the time at which the contract is opened and the time at which it is closed. A CFD is an agreement to exchange the difference in current value of a share, currency, commodity or index and its value at the end of a contract. If the difference is positive, the seller pays the buyer a commission and if the difference is negative, the buyer loses the money he had invested.

A CFD contract is normally between an individual trader and a CFD provider. CFD financing allows a buyer to speculate on the price movements of a financial commodity without actually owning the underlying commodity. This is because contracts for difference are traded on margin where the buyer needs to take out a position in an instrument or commodity by fencing a portion of actual value of the instrument. The profit or loss in a CFD agreement is determined by the difference between the buying price of the commodity and its selling price at the close of the contract.

CFD trading is initiated by making an opening trade on an instrument through a CFD provider. This creates a ‘position’ for a buyer in that instrument. CFD positions have no expiry date but it is common among traders to hold out a position for a day. Any position left open overnight will result with any profit and loss realized being credited or debited to a buyer’s account and the financing charges calculated. The position is then carried forward to the next day. However, the buyer must maintain the minimum margin at all times his position is open. This means that the amount of money the buyer fenced to take out a position in the instrument should not depreciate while his position is open. If the margin level drops, a CFD provider can liquidate the position of the buyer resulting in a loss therefore traders/buyers need to cover the margin quickly to avoid this. Interest rates are determined on a day to day basis and they don’t apply to positions opened and closed on the same day. Only positions that have been ‘rolled over’ overnight will attract interest rates.

To hedge your position in an instrument, a CFD provider will buy the underlying instrument when you enter a position and to do this, he has to shore up the entire purchase cost. In effect, the CFD provider is lending you money to own the instrument temporarily when the contact is still open. For this, the CFD provider will charge interest on the cash he has ‘loaned’ you which comes in form of commissions based on the percentage of the size of the position for each trade. You can also trade a CFD short to receive the money for that sale. However, this will not end up in your bank account but in the providers’ account.

Anna Edgley is the author of this article on CFD Trading. Find more information on CFD here.

Article Source: Understanding How CFD Financing Works

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