Contracts for difference trading, otherwise known as CFD trading, are financial derivatives which rely on speculative decisions about which way the market will go and is similar to standard share trading. The “contract” is between two parties, referred to as the “buyer” and “seller”, and stipulates that the buyer will pay the seller, the difference between the current value of an asset and its value at contract time. (Wikipedia, Contract for difference, 2012).

Trading in Contracts For Difference (CFD), has risen in popularity over recent years as it makes use of rising and falling markets, and leverage to enhance gains. There consists of three main market models in the world of CFD trading. The first is the traditional Over-The-Counter (OTC) derivative, which is usually traded with a broker or market maker. The second is the Direct Access (DMA) model, and the third is a more recent introduction, that of exchange-traded CFDs.

The CFD provider will always set out the contract terms, margin rates and which underlying instruments it is willing to trade. In order to start trading and open a position, an initial margin is required and defined by the broker or the market maker. This usually ranges from anything from 0.5% to 30% of the initial investment, depending on liquidity. Variation margin is applied, when the instrument is marked to market, and if the position becomes unfavorable. Variation margin is applied in order to prevent the positions from closing.

The price of the underlying instrument traded depends on which model is chosen:

A Broker/Market maker is usually the preferred choice, and the contract exists between the trader and the CFD provider. The provider will set the price of the CFD on the underlying instrument, and takes all orders onto their own book. They will then hedge their clients’ positions according to their own risk model. Utilizing this model means that the price of the CFD differs from the underlying physical market. This is because the provider has a range of options available – from hedging other positions, creating hybrids, and hedging using alternative instruments to allow trading when markets are closed

Direct Market Access, as the name suggests, allows CFD traders to view and interact with the live order books of global exchanges. DMA was created in response to concerns that the price in the market maker model doesn’t always align with the underlying instrument and match the same price. The provider assures the trader it will perform a physical trade on the underlying market to match each CFD. The trader does not have ownership of the underlying instrument as in the Exchange model

CFD trading through an Exchange means reducing counterparty risk, increasing transparency and market independence, but as a result drives costs higher. The downside, however, to this model is that orders are placed on a separate book. In addition CFD trading through a centralized exchange is very much dependent on attracting enough participants to its CFD products in order to create a liquid market.

Disclaimer – FX and CFDs are leveraged products that can result in losses exceeding your deposit. They are not suitable for everyone so please ensure you fully understand the risks involved. The information in this article is not directed at residents of the United States of America or any other jurisdiction where trading in CFDs and/or FX is restricted or prohibited by local laws or regulations.

This post was written by Nick Taylor on behalf of LMAX Exchange – a retail contracts for difference (CFD) and FX trading venue. Nick regularly contributes to various financial news blogs and main interests including stocks, shares and CFD trading.

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