Contract for Difference (CFD)

A Contract for Difference (CFD) is a popular type of Derivative that allows a trader to speculate on the future price movements of an Underlying Asset without actually owning it. Think of it as a formal bet between you and a Broker. The contract stipulates that the buyer will pay the seller the difference between the asset's current value and its value at the time the contract is closed. If the price goes up, the buyer profits and the seller pays. If the price goes down, the seller profits and the buyer pays. CFDs can be based on a huge variety of assets, including stocks, stock indices, commodities, and currencies. Because they don't involve physical ownership, they offer a high degree of Leverage, which allows traders to control a large position with a small amount of capital. However, this leverage is a double-edged sword, capable of magnifying losses just as quickly as it magnifies gains, making CFDs an extremely high-risk instrument, especially for inexperienced investors.

Imagine you and a friend are watching the price of a vintage comic book, currently valued at €100. You believe its value will rise, but you don't want to go through the hassle of buying, storing, and insuring the actual comic. Instead, you make a deal with your friend: a Contract for Difference.

• You “go long” by betting the price will increase.
• Your friend, who provides the contract (acting like a broker), takes the other side of the bet.

A week later, a new superhero movie is announced, and the comic's value shoots up to €120. You decide to “close your position.” According to your contract, your friend owes you the difference: €120 - €100 = €20. You made a profit without ever touching the comic book. Conversely, if the comic's value had dropped to €90, you would have had to pay your friend the difference: €100 - €90 = €10. This is known as “going short”—profiting from a fall in price. If you had initially bet the price would fall (gone short) and it did, you would have made a profit. In the real world, a broker charges fees for these services, such as a Spread (the difference between the buy and sell price) or overnight financing costs.

The most seductive—and dangerous—feature of CFDs is leverage. A broker might offer 10:1 leverage, meaning for every €1 you put down, you can control a €10 position. This deposit is known as Margin.

Let's say you want to trade CFDs on a company whose shares are €100 each. You believe the price will rise.

• The Position: You decide to control 100 shares, a total position value of 100 x €100 = €10,000.
• The Margin: With 10:1 leverage, you only need to deposit 1/10th of the position's value. Your required margin is €1,000.

The share price rises by 5% to €105. Your position is now worth €10,500. You close the contract.

• Profit: €10,500 - €10,000 = €500.
• Return on Investment: You made a €500 profit on your €1,000 deposit. That's a 50% return from a mere 5% move in the underlying asset's price. Leverage worked its magic.

The share price falls by 5% to €95. Your position is now worth €9,500.

• Loss: €10,000 - €9,500 = €500.
• Return on Investment: You lost €500 of your €1,000 deposit. That's a 50% loss from a 5% price move. If the share price falls by 10%, your entire €1,000 deposit is wiped out. If it falls further, you could owe the broker more than your initial deposit (though many jurisdictions now require negative balance protection for retail clients). If your losses grow too large, the broker will issue a Margin Call, demanding you add more funds or they will automatically close your position, locking in your loss.

For a follower of Value Investing, CFDs exist in a different universe. The philosophies are fundamentally opposed.

• Ownership vs. Speculation: Value investing is about owning a piece of a real, productive business. You receive Dividends, have voting rights, and share in the company's long-term success. CFD trading is pure Speculation on price movements. You own a contract, not a company. It's a bet, not an investment.
• Time Horizon: Value investing is a long-term game. You buy with the intention to hold for years, allowing the company's Intrinsic Value to grow. CFDs are overwhelmingly used for short-term, often intraday, trading.
• Risk Management: The value investor's primary concern is the avoidance of permanent capital loss, achieved through a Margin of Safety. The CFD trader, by using leverage, actively takes on immense risk where a small adverse price movement can destroy their capital.
• The Nature of the Game: Investing in good companies is a positive-sum game. As businesses create value, the overall economic pie gets bigger, and multiple investors can profit. CFD trading is a Zero-Sum Game (or negative-sum, once you account for broker fees). For every winner, there must be a loser. Your profit comes directly from another trader's loss.

While CFDs may seem like a shortcut to quick profits, they are one of the fastest ways for an ordinary investor to lose money. European regulators have stated that 74-89% of retail investor accounts lose money when trading CFDs.

• CFDs are complex, high-risk instruments designed for short-term speculation.
• They are not a form of investment. You are not buying a part of a business.
• Leverage is the key danger, amplifying losses to a potentially catastrophic degree.
• For the value investor focused on building long-term wealth through ownership of great companies, CFDs are a dangerous distraction to be avoided.