Contract for Difference

Cash-settled exposure to a price move

A contract for difference pays the change in an asset’s price between opening and closing a position, in cash, with no ownership of the asset at any point. It is traded on margin with a dealer as the counterparty on every trade, which makes it a cheap way to take a leveraged position in either direction — and the reason regulators have singled it out, banning it for retail clients in the US and capping the leverage retail clients may use in the UK and EU.

Open in the app · Equity · foundational

The lesson

1. What it is

A contract for difference is a bilateral agreement to exchange the change in an asset’s price between opening and closing the position. The asset itself is never owned or delivered — only the difference is paid in cash. The dealer offering the contract is the counterparty to it, so there is no exchange and no clearing house involved.

CFDs cannot be sold to retail clients in the United States, where off-exchange contracts of this kind are prohibited; the equivalent exposure there is taken through listed futures, options or a margin account.

2. How it works

The position is opened on margin, so only a fraction of the notional is posted upfront. Gains and losses are credited or debited daily, a financing charge accrues for as long as a long position is held, and closing the contract settles the cumulative difference. Financing is calculated on the full value of the position rather than the margin posted, and equity CFDs carry a dividend adjustment: longs are credited when the share goes ex-dividend and shorts are debited.

3. Why it’s used

It gives leveraged exposure in both directions — going short is as straightforward as going long — and avoids the settlement and custody involved in owning shares outright. That makes it popular for short-term trading and tactical hedging, particularly where a trader wants to be short without arranging a stock borrow themselves.

Buying UK shares attracts 0.5% stamp duty reserve tax; a CFD on the same shares does not, though any profit remains subject to capital gains tax.

4. Key terms

Margin, leverage, the overnight financing charge, the dealer’s spread, and the close-out that settles the position. The dealer is the counterparty on every trade rather than an exchange. A margin close-out is the separate mechanism by which the dealer shuts positions once account equity falls below a set fraction of the margin required to hold them.

5. Risks to watch

Leverage cuts both ways: a loss is calculated on the full position, not the margin, so it can consume the margin posted and keep going into the rest of the account. Daily marking means an adverse move triggers margin calls quickly, financing costs erode returns the longer a position is held, and holders get no ownership or shareholder rights. UK and EU retail clients do have negative balance protection, which stops an account being taken below zero — professional clients do not.

FCA and ESMA rules cap retail leverage at 30:1 on major currency pairs and 5:1 on individual shares, close out positions at 50% of required margin, and require firms to publish the percentage of retail accounts that lose money.

A leveraged long, held for three weeks

• A trader buys a CFD on 1,000 shares quoted at £50 — a position worth £50,000.
• Retail share CFDs require at least 20% margin, so £10,000 is posted.
• Financing accrues on the full £50,000 at 6.5% a year: over 20 days that is £50,000 × 6.5% × 20 ÷ 365 = £178.
• The shares rise to £53 and the position is closed, a price gain of 1,000 × £3 = £3,000.
• Net of financing the trader makes £2,822 on £10,000 of margin — a return of 28%.

A 6% move in the share produced a 28% return on the margin posted. Had the shares fallen to £47 instead, the same £3,000 move plus £178 of financing would have taken £3,178 — nearly a third of the margin — out of the account.

Key terms

• Margin — The cash posted to open and maintain a position, a fraction of its full value.
• Leverage — The ratio of position value to margin posted, which magnifies gains and losses alike.
• Overnight financing — The daily charge for funding the full value of a long position, accruing for as long as it is held.
• Spread — The gap between the dealer’s buy and sell prices, paid on entry and exit of every trade.
• Margin close-out — The dealer’s closing of positions once account equity falls below a set fraction of required margin.
• Dividend adjustment — A cash credit to long positions and debit to short ones when the underlying share goes ex-dividend.

In practice

CFDs are mostly used by retail and professional traders at online brokers in the UK, Europe, Australia and Singapore for short-dated directional bets and for shorting a share without arranging a borrow. Institutions take the same synthetic exposure through equity swaps with a prime broker instead, and no CFD is available to a US retail client at all.

Read next

• Equity Swap — Swap equity returns for a funding rate
• OTC Equity Option — A custom, bilaterally negotiated option
• FX Forward — Lock in a future exchange rate

The app adds a twelve-question bank for Contract for Difference, drawn differently every sitting, and a review queue for whatever you miss.

A subscription adds 3 further sections on Contract for Difference — Financing, day by day, Close-out, and how fast it happens, Dividends, and what a synthetic holder receives — and 12 more questions to its bank.

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Educational content only. Nothing here is financial advice, an offer to trade, or a recommendation to buy or sell any instrument.