A contract for difference, often abbreviated to CFD, is an alternative means by which an individual can invest in a company or asset.
While CFDs are relevant primarily to independent investors, they are also interesting for a company to keep in mind because, in a way, they’re hidden investments. They are affected by share price, but, crucially, do not in turn impact where that price goes.
In our analysis of price to book ratio, we noted that a company’s “market value” is the amount that its stock is selling for on the market (as opposed to “market cap,” which is the total value of its stock). The market value is used as part of the equation that essentially determines if a stock is over- or under-valued. But this isn’t the only reason market value matters to a lot of companies.
The market value can also have a significant impact on companies that depend on outside financing to operate. As one article explaining why companies care if their stocks lose value put it, a company doesn’t necessarily take a direct hit if its stock is sold for a loss. That is, if you buy Apple at $300 and sell it at $250, the company is going to be fine. A smaller company though, without massive reserves of cash on hand, will be impacted if its share prices drop — not least because it will be less attractive to investors or lending companies that take share price into account when evaluating strength and potential.
All of this matters with regard to CFDs because they represent indirect investments that don’t show up in market value. To define them more clearly, CFDs allow people to trade shares of popular stocks (and other assets) without taking possession of those shares. The basic idea is that a CFD represents an investor’s general expectation as to whether a stock will increase or decrease in value. The investor effectively “bets” on or against the share price, and profits if he or she is correct that said price will rise or fall in the allotted period of time. But at no point does the investor buy or sell actual stock — meaning that at no point is the market value affected.
CFDs generally appeal to investors who are looking for simpler ways to trade in the market. There are many such investors out there, which is one reason that mutual funds are still so popular, as well as that low-fee, semi-automated investment apps have become something of a sensation. Investors don’t always want the full responsibility of trading on the day-to-day fluctuations of a share price, so they opt for alternatives that allow them the chance to profit off of the same movements, but with fewer decisions to make.
That’s all well and good, but it can make things more difficult for companies looking to assess their own true strength. While share price indicates the most technical representation of market value at any given moment, it’s possible that a company could also be generating a significant number of buy or sell orders from CFD traders that would speak more to market confidence in the company.
For instance, if Apple is trading at $300, its market value is $300. But if 80% of CFD traders are also “buying” shares in Apple (meaning they’re betting on a rising price), it might suggest, in non-technical terms, that the market’s confidence in the stock is greater than the share price of $300 indicates.
FAQs
1. What is a contract for difference (CFD)?
A contract for difference (CFD) is a derivative product that allows you to trade on the price of an underlying asset without having to own the asset.
2. How does a contract for difference (CFD) work?
A CFD is a contract between two parties - the buyer and the seller. The buyer agrees to pay the seller the difference between the price of the underlying asset at the time of purchase and at the time of sale, minus any fees.
Let's say you buy a CFD on Apple shares for $300. If the price of Apple shares rises to $350, you will sell your CFD for $50 (the difference between $350 and $300). You will then have made a profit of $10 (minus any fees).
3. What is the difference between the contract for difference (CFD) and the options?
A CFD gives the buyer the right to buy or sell the underlying asset at the agreed-upon price, while an option gives the holder the right, but not the obligation, to buy or sell the asset.
4. How long are contract for difference (CFD) contracts?
A Contract for Difference (CFD) has no set expiry date, unlike an option that has a set expiry date. The contract will continue until it is canceled or filled.
5. How is a Contract for Difference (CFD) taxed?
Any profits made from trading CFDs are taxed as capital income and are subject to capital gains tax.
