What am I actually buying when trading in CFDs?

Question

I'm trying to figure out what is actually happening when I'm trading in CFDs (Contract for Differences).
Investopedia says:

This is generally an easier method of settlement because losses and gains are paid in cash. CFDs provide investors with the all the benefits and risks of owning a security without actually owning it.

But I have no idea what it means. From what I managed to figure out, I'm just betting on whether stock price will rise or fall and I have no connection to the real stock market?

GS - Apologise to Monica · Accepted Answer

The economic effect of a CFD from your point of view is very close to the effect of owning the stock. If the stock goes up, you make money. If it goes down you lose money. If it pays a dividend, you get that dividend.

You'll typically pay commission for buying and selling the CFDs in a similar way to the commission on stock purchases, though one of the advertised advantages of CFDs is that the commission will be lower.

They also often have tax advantages, for example in the UK you don't have to pay stamp duty on CFDs.

In theory you are exposed to credit risk on the CFD issuer, which you aren't with the real stocks: if the issuer goes bankrupt, you may lose any money you have invested regardless of how well the stock has performed.

It's certainly similar to a bet, but not much more so than investing directly in the stock. In practice the issuer of the CFDs is likely to hedge its own exposure by actually buying the underlying stocks directly, but they can aggregate across lots of contracts and they would tolerate some unhedged exposure to the stock, so they can cut down on the transaction fees.

You also won't get the same voting rights as the underlying stock would grant you.

JTP - Apologise to Monica · Answer

The product itself is a derivative as it derives its value from another stock or commodity.

It's similar to a US option, which offers (in the case of a 'call') the right, but not the obligation to buy a stock at a predetermined price before a certain date.

But, unlike the US option, instead of buying the stock, the contract is only closed out in cash. I've made the analogy to betting, so I believe it to be a fair comparison. I hope this question is theoretical. You should never buy a financial instrument with no clue how it works.

Victor · Answer

CFDs (Contracts for Difference) are basically a contract between you and the broker on the difference in price of the underlying between the time you open a position and close a position. You are not actually buying the underlying.

With share CFDs, the outcome is a bit like buying the underlying shares on margin. You pay interest for every day you hold the CFDs overnight for long CFDs. However, with short positions, you get paid interest for every day you hold your short position overnight.

Most people use CFDs for short term trading, however they can be used for medium to longer term trading just as you would hold a portfolio on margin. What you have to remember is that because you are buying on margin you can lose more than your initial contract amount. A way to manage this risk is by using position sizing and stop loses. With your position sizing, if you wanted to invest $10,000 in a particular share trading at $10 per share, you would then buy 1000 shares or 1000 CFDs in that share. Your initial expense with the CFDs might be only $1000 (at a margin rate of 10%). So instead of increasing your risk by having an initial outlay of $10,000 with the CFDs you limit your risk to the same as you were buying the shares directly.

What am I actually buying when trading in CFDs?

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