What is a contract for difference? In general, it is an agreement between two parties to purchase and sell a security at a future point in time. This type of agreement can be used to hedge risk or speculate on price movements.
Let’s have a look at the techniques:
The first one is called hedging. For example, if you are an investor in a company, and the price of its shares is likely to increase over time, you can enter into a contract for difference with another party (for example, your bank) at an agreed-on fixed rate on whether the value will go up or down after some time.
If it goes up, you will receive $X of dividends for that investment; if not, you lose out on this portion of the money.
This type is called “cash-settled” since both parties settle their obligations by transferring cash—not actual securities—to each other when they come due.
If one wants to speculate using the technique of CFD, they do not need to keep the open position until maturity. This is called “speculating on margin.”
This means that speculators can buy or sell securities without actually owning them by using leverage (borrowed funds) and place bets on whether prices will rise or fall.
Speculation in CFD’s, however, does require traders to deposit cash or shares with the broker that is proportional to their exposure.