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Trading instruments revealed: What are CFDs?

by , 02 May 2014

Contracts for difference (or CFDs) fall into the derivatives category. This simply means they derive their value from something else. For example, a Sasol CFD ‘derives' its value from a Sasol share. So what exactly is a CFD? And what can you trade with CFDs? Let's delve a little deeper…

What is a CFD?

Firstly, CFDs are over the counter (OTC) derivatives. This means they don’t trade on an exchange, like a share does on the Johannesburg Stock Exchange. Instead they trade through a market maker.

The market maker is either a bank or a company providing CFD trading. In SA, this includes Global Trader and Nedbank.

These ‘market makers’ make a market for the trading of CFDs to occur, the FSP Invest team in The Ultimate Contracts for Difference Guide explain. They also ensure there’s suitable liquidity in the market. If they didn’t make the market, you wouldn’t be able to trade CFDs.

How do CFDs work?

One CFD is equal to one underlying share.

This makes CFDs slightly different to other derivatives. For example, with single stock futures, one contract is equal to 100 underlying shares.

So if you buy one Sasol CFD, your trade equals one underlying share of Sasol.

A CFD trade is an agreement between two parties to exchange the difference between the closing price and the opening price of the contract. The parties involved are you as the trader and the market maker.

Settlement of the difference between the closing price and the opening price is by cash payment. Unlike futures, there’s no risk of actual delivery of the shares.

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What can you trade with CFDs?

You can trade CFD on stocks and indexes. And depending on who you trade with, you may also be able to trade international CFDs. This could include currencies too.

CFDs tend to be available on all liquid larger companies. For example, you’ll probably not find penny stocks with CFDs to trade.

So there you have it, what CFDs are.

Trading instruments revealed: What are CFDs?
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