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Definition: Contract for Differences (CFD)
It refers to an arrangement in a typical futures contract that allows the buyers and sellers to settle the positions in cash rather than through delivery of actual physical goods (commodities, securities). It allows investing on margin requirement and hence allows to get high return on investment. The following example describes how can an investor get a high return on investment using margin investment rather than the traditional theory of investing by actually owning the underlying asset (security).
Let’s say a person wants to invest in a stock worth $50. He wishes to buy 100 units of the stock, So the total money required for initial investment is equal to $5000. But, under CFD let’s say the margin requirement is 5%. So the total initial investment comes down to $250.
Suppose the stock price increases by $1, then the gain for the person is $100. Now if the person has not used CFD, then the return on investment comes out to be 2%. But on the other hand, under CFD, the return on investment comes to be 40%, which is way higher than the initial return on investment.
That’s the power of using CFD. The margin requirements under CFD varies from exchange to exchange and generally falls in the range from 2% to 10%.
It allows high leverage that is the margin requirement is as low as 2%. Hence the return on investment is very high if an investor uses contract for difference.
It only allows the underlying asset to be possessed for short term (in the range of 3 months to 12 months, depending on the exchange). But, generally value investors look for a horizon period of more than 1 year and hence it is not suitable for value investors. This technique is mostly used by speculators and short term investors.
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