Defining CFD: What does Contract for Difference Mean?

Have you ever heard of a CFD, or contract for difference? This is a very important term for people looking to invest in futures. If you’re thinking about investing in these financial instruments, you need to make sure you understand how a CFD works. Before you understand this term, however, you need to understand futures.

What are Futures?

Futures originally evolved as a way for sellers of certain goods, often commodities such as wheat and corn, to sell their goods before they had been harvested or obtained. Sellers, meanwhile were able to secure supplies in advance. The benefits of these contracts should be obvious. For crop growers, miners, oil drillers and other people harvesting commodities they can secure funding to pay for seed, equipment, or whatever else they need.

Meanwhile, those who need supplies of commodities can ensure that they have the needed supplies. This is especially important for people who plan on refining commodities into finished goods. If you happen to be a clothing manufacturer who uses cotton to make clothing, ensuring a steady supply of cotton is essential.

Buyers and sellers can use futures to accomplish all of this. Both parties agree on a certain price and amount and exchange the cash in the present, while the seller delivers the goods in the future when they are available.

Investors quickly figured out that they could make money off of futures through speculation. If you buy a future for corn delivery now, and corn prices rise over the next six months before the contract expires and the corn is delivered, you could then sell the corn you bought at a profit. Within this context, futures quickly emerged as one of the most popular forms of investments.

Why CFD’s Are Important

Of course, most investors don’t want to take delivery of corn, cattle, oil, or any other commodity. Under a standard futures contract, however, once an expiration date is reached, the goods must be delivered. That’s where contracts for difference came into play.

With a contract for difference, the company facilitating the future, such as Barclays, will simply offer to pay the difference. The buyer of the future must likewise pay the facilitator for any money lost.

Let’s say you buy a gold future for 10 troy ounces of gold for $10,000 U.S. dollars with a six-month expiration date. With no CFD you’d have to take delivery of the gold when the contract expires. In this case, however, a contract for difference is drawn up. If gold rises to $1,500 an ounce, the facilitator of the contract will have to pay you the difference, in this case $5,000. If prices drop, however, to say $500, you will owe the brokerage or other financial institution $5,000.

Generally, you can buy and sell futures up until their expiration date. Often, other buyers will be looking to buy and sell futures. However, you should know that in some instances futures markets won’t be as liquid as stock markets and other financial markets.

Futures and CFDs vs. Stocks

It should be pretty clear why so many investors like futures and CFDs. They offer a great alternative to stocks. Many investors feel that the research, analysis, and predictions involved in futures trading is actually easier than with stocks. Instead of looking at dozens of individual companies, futures traders can focus on mega-trends, weather, and other trends and patterns. Some simply prefer this to digging through company financials.

Of course, predicting megatrends is certainly no easy task and many things are near impossible to predict. For example, weather trends are notoriously difficult to predict, even for the most well trained professionals. Further, some events, like droughts, diseases that kill off crops, and natural disasters, are also very hard to predict or anticipate but can have a huge impact on futures.

When it comes to investing, however, risk means reward. Futures can be relatively high in risk, but they can also be very high in reward. Futures aren’t for everyone, of course. However, if you are interested in them, you should check out your current stock broker, if you have one, and also other brokerage firms. Some specialized futures brokerage firms actually offer better prices when it comes to trading futures.

Just remember to always keep an eye on whether you bought a future with a contract for difference, or you might find someone trying to arrange the delivery for a truck full of cows to your house!