Contracts for Difference (CFD) are a financial derivative that allows investors to reap the gains or losses from a financial instrument without actually owning it. Since their creation in the 1980s, CFDs have been gaining popularity with different classes of investors. In recent years, they have even become accessible to everyday, retail investors.
For instance, in buying a EUR/USD Contract for Difference you would be entitled to the profit or loss that the trading pair incurs over the duration of ownership. You do not need to actually own Euros or U.S. Dollars to buy into this contract. This is because you are not actually buying the pair, but only a contract that entitles you to its rewards or losses on its price movements.
Recently, bitcoin has become popular in CFD pairs. Many brokerage firms have even adopted bitcoin trading platforms, which hold bitcoin as the base currency for profits and losses. Even some big-name brokers have begun to pick it up, with Plus500, Avatrade being among the largest and most popular.
Bitcoin Contracts for Difference are treated the same as any other CFD. They entitle you to either a profit or loss in relation to a rise or decline in the price of an underlying asset, often the BTC/USD pair, but without actually owning that asset. As bitcoin is the base currency, though, returns and losses will be delivered in bitcoin.
Contracts for Difference are priced according to the underlying asset. For instance, for a stock MNO which is selling on the market at $25, it will cost you $25 to buy a contract for difference equivalent to one share. This is because many brokers will buy shares of MNO equivalent to the number of shares agreed to in the CFD in order to hedge against the risk that they will lose money if the CFD appreciates.
You may be wondering how brokerages can make money . They profit from something called the “ bid-ask spread.” The spread is the difference between the bid price, the price at which you can buy an asset, and the ask price, the price at which you can sell an asset. Let’s go back to stock MNO to illustrate this.
You already know that you can buy MNO for $25 per share. That is the bid price. If you already own MNO, though, you can sell it at $24.95, the ask price. The difference between these two prices is called the spread; which in this case is $0.05. So, the broker makes $0.05 every time someone buys and another sells the MNO contract for difference. Brokers accommodate constantly changing prices by continuously updating their bid and ask prices in real-time.
There are two different types of CFDs. The first is treated almost exactly as if you actually owned the asset that the contract is for. You can sell out any time that your brokerage is open. Besides the ability to invest in alternative currencies than what the asset is listed in, there is only one real difference: overnight fees. These will be discussed at the end of the article.
The second type is a “futures” contract for difference. In this instrument, a futures contract is combined with a contract for difference. It entitles the buyer of the contract to sell the CFD to the seller of the contract for a fixed price at a fixed time in the future.
Often these contracts are used to “short”, or bet on a price decrease, without actually having to go through the complicated, and sometimes illegal, procedure to short the actual asset on the open market. Instead, the seller of the CFD simply agrees to pay the buyer if the asset decreases in value and the buyer agrees to pay the seller is it increases.
As an added perk, many CFD brokers allow steep leverage on investments, so that you can amplify the potential profit/loss on your money. For instance, imagine that you have $2,000 to invest. After doing some research, you decide to buy “redeemable-at-will” CFDs from a CFD broker on stocks ABC and XYZ; both priced at $5. For stock ABC, you put in $1,000 at the 10% margin requirement, giving you $10,000 in profit/loss potential. For stock XYZ, you put in the other $1,000, but do not use margin.
During the course of the day, both stocks increase by 5% and you cash out. Given the $10,000 potential for stock ABC, you earn a hefty $500 return on your initial investment of only $1,000. Without leverage, stock XYZ earns only $50. While you are liable to just as dramatic losses if the price had fallen, leverage is a great way to increase returns for investors with high levels of risk-tolerance.
Contracts for difference are especially useful for investors who wish to invest in indices. Like index futures, CFDs give exposure to the market, but without exposing investors to time decay, or a suppressive force on the price of an option or futures contract as it nears its expiry date.
One important factor to consider if you planning on holding a contract for difference overnight is the overnight fee. This fee is charged if you hold a CFD shares, that you had bought with margin, overnight. The reasons charge this fee on claims that they have lent you money for the amount of the margin and consider the overnight fee an interest charge on that investment. If you never hold overnight, you will not have to worry about this fee.
Contracts for Difference can be a great way to invest in bitcoin price movements without actually having to own any of the virtual currency as well as a great way to invest in other liquid assets with bitcoin. As bitcoin works its way farther and farther into mainstream culture and finance, opportunities and demand for these contracts denominated in bitcoin will only increase, giving investors like you more and more opportunities to profit.
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