Most traders understand the concept of trading on margin – borrowing money from your broker to purchase shares. Margin amplifies your profits and your losses, because you have leveraged your position through a loan. An interesting financial instrument that I was not familiar with is the Contracts for Difference (CFD). The trader using a Contract for Difference provider will enjoy the ability to leverage their account in trading any number of instruments and markets, like ETFs, FOREX, commodities, bonds, and indices. The curious thing about how CFDs work compared to an online stock market trading broker is how the two organizations create leverage for a trader.

A stock broker will lend money to the trader, giving him more cash to purchase a position. Depending on the country, the leverage in a margin account is limited – like in the US it is only 50%. So, if a trader wanted to buy 100 shares of XYZPDQ at $10 per share, and had at least $500 in his margin account – then he could purchase $1000 worth of XYZPDQ shares. CFDs gives traders much more leverage – depending on the market being traded.

The way a CFD works is the trader wants to purchase something like an Oil ETF, but he has very limited funds. The trader can purchase up to 10 times the amount in his account with a CFD. Rather than lending money to the trader, the CFD Providers will write a contract for difference for the trader and then hedge their transaction – a short position on their side when they create the contract – by purchasing shares of the ETF in the cash market. The CFD provider has a neutral position, the trader gets the best market price for his transaction as well as a leverage of up to 1000%.

Trading CFDs is an excellent tool for the very short-term trader who is certain about the direction that a market is moving in and willing to take the risk involved with high leverage trading. Unlike like standard stock trading programs, CFDs are derived financial instruments – they derive their value from the underlying commodity, stock or index that the CFD is written against. This derivation of value is passed directly to the trader without the complexities of instruments like options and warrants, but in a cost effective manner and with similar levels of leverage potential.