CFD stands for Price Difference Contract. It is a financial derivative that allows you to profit when the stock quotes rise or fall. Trading this instrument poses a huge danger to private investors.
Invention
Price difference contracts first appeared in the UK in the 90s of the last century. In the early stages, they were a type of stock swap intended for margin trading. Their invention is attributed to Brian Kilan and John Wood, employees of the Swiss investment company UBS.
Initially, price difference contracts were used by institutional traders to reduce costs when hedging open positions on the London Stock Exchange. The main advantages of the new derivative financial instrument were the small amount of guarantee coverage and the absence of the need to supply cash shares.
Small traders
In the late 1990s, price difference contracts were presented to private investors. Several British companies that developed innovative trading platforms took part in their popularization. New terminals allowed traders to monitor quotes and complete transactions in real time.
Soon, small speculators realized that the main advantage of price difference contracts is the ability to sell and buy any underlying asset using a large leverage. This circumstance was the impetus for the rapid growth in the popularity of CFDs. What does this mean in practice? How skillfully was this tool used? CFD brokers quickly added stock indices, commodities, bonds, and currency pairs to the list of available underlying assets.
Financial betting
Many people notice the similarity of price difference contracts with another UK derivative. Trading CFDs has the same economic effect as making financial bets. This term refers to cash rates for changing any exchange quotes. They are accepted by special organizations working on the principle of bookmakers. In the UK, this type of activity is not officially considered a business, but a gamble.
Inevitable risks
The specifics of margin trading is the main danger that awaits buyers and sellers of CFDs. What it is? The use of credit leverage multiplies both profits and losses of participants in transactions. With margin trading, market risk sometimes reaches levels that go beyond common sense. A strong and rapid change in quotes can lead to the loss of all investor funds.
Counterparty risk should also be taken into account in a CFD transaction. What does it mean? Decentralized markets are characterized by an imperfect system of control over the adequacy of participants' funds. Even a profitable transaction can cause losses to the trader if the counterparty fails to fulfill its financial obligations. Therefore, this danger is common to all OTC derivatives.
Comparison with other markets
There are types of exchange trading more traditional than CFDs. What are these markets and how do they differ from price difference contracts? Transactions with cash shares without the use of marginal lending are considered the most conservative and relatively safe. They have very little in common with CFDs, since they imply a real change of ownership of securities.
Far more risky are instruments such as futures and options. Transactions with them contain elements of a rate on price changes and are somewhat reminiscent of CFD trading. However, futures and options are traded on an organized exchange market, where the risk of counterparty defaults is minimized. In addition, pre-established expiration dates guarantee investors the closure of positions even in the case of absolute illiquidity of instruments. Contracts for price differences have an unlimited circulation period, and the termination of obligations on them occurs only after the conclusion of a mirror transaction. If there are no potential sellers or buyers in the market, closing positions can be a serious problem.
