Contract for Difference (CFD) [CapiPedia]

This page is read only. You can view the source, but not change it. Ask your administrator if you think this is wrong.
======Contract for Difference (CFD)======
A Contract for Difference (CFD) is a popular, high-risk type of financial [[derivative]] that allows you to speculate on the future price movements of an asset without actually owning it. It is, in essence, a formal agreement between you and a [[broker]] to exchange the difference in the value of an [[underlying asset]] from the moment the contract is opened to when it is closed. These underlying assets can be anything from stocks and commodities to indices and cryptocurrencies. Because you never take ownership of the asset, CFD trading is purely about betting on price direction. If you correctly predict the price movement, you make a profit on the difference. If you are wrong, you incur a loss for the difference. While this might sound straightforward, the mechanics of CFDs, particularly their use of leverage, make them one of the riskiest instruments available to retail investors and fundamentally incompatible with a [[value investing]] philosophy.
===== How Do CFDs Work? The Mechanics =====
Imagine you believe the stock of "Espresso Express," currently trading at €100, is going to rise. Instead of buying the actual stock, you could open a CFD.
  * **Going Long:** You open a "buy" CFD, also known as a [[long position]]. If the stock price rises to €105 and you close your position, the broker pays you the €5 difference (minus any costs).
  * **Going Short:** Conversely, if you believed the stock was overpriced and would fall, you could open a "sell" CFD, or a [[short position]]. If the price dropped to €95 and you closed your position, you would again pocket the €5 difference (minus costs).
Of course, the market can just as easily move against you. If you went long at €100 and the price fell to €95, you would owe the broker the €5 difference upon closing the position. The core transaction is always about the //change// in price, not the asset itself.
===== The Allure and the Dangers =====
CFDs attract traders for one primary reason: leverage. However, this feature is a double-edged sword that magnifies both gains and, more critically, losses.
==== The Siren's Song: Leverage ====
[[Leverage]] allows you to control a large market position with a relatively small amount of capital, known as [[margin]]. For example, with a 10:1 leverage ratio, you could use just €1,000 of your own money to control a €10,000 position.
If the position moves 5% in your favor (to €10,500), your profit is €500. On your initial €1,000 margin, that's a spectacular 50% return. This is the allure.
However, the danger is symmetrical. If the position moves 5% //against// you (to €9,500), your loss is €500. This represents 50% of your initial capital. A mere 10% adverse move would wipe out your entire margin. If losses exceed your margin, your broker will issue a [[margin call]], demanding you deposit more funds immediately or they will automatically close your position, locking in your substantial losses.
==== The Hidden Costs ====
CFD trading is far from free. Several costs eat into any potential profits:
  * **The Spread:** There is always a difference between the buy price and the sell price offered by the broker. This is the [[spread (Bid-Ask Spread)]]. You buy at a slightly higher price and sell at a slightly lower price, meaning every trade starts with a small, instant loss.
  * **Overnight Financing:** If you hold a position open past the market's closing time, you will be charged a daily interest fee known as [[overnight financing]]. This is because, through leverage, you are effectively borrowing from the broker. These fees can quickly accumulate and turn a potentially profitable trade into a loser.
  * **Commissions:** Some brokers may also charge a commission for each trade, in addition to the spread.
===== A Value Investor's Perspective =====
For a value investor, the conclusion is simple and stark: **CFDs are tools for [[speculation]], not investment.**
The father of value investing, [[Benjamin Graham]], famously distinguished the two: "An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative." CFDs fail this test spectacularly. There is no safety of principal; in fact, regulatory bodies in Europe and the UK have consistently found that 70-80% of retail clients lose money trading CFDs.
A value investor like [[Warren Buffett]] seeks to buy a piece of a wonderful business at a fair price, focusing on its long-term [[intrinsic value]] and productive capacity. A CFD, by contrast, has no intrinsic value. It is a zero-sum bet on price fluctuations, and once broker costs are factored in, it becomes a negative-sum game. You aren't investing in a company's future earnings or its competitive advantages; you are simply betting against another trader, with the house (the broker) always taking its cut.
While professionals might use CFDs for complex [[hedging]] strategies, for the ordinary investor, they are a direct path to financial peril, encouraging short-term gambling over patient, long-term wealth creation.