Contracts for difference (CFDs) are the third derivative that can be used for gold investments. They are financial instruments that are similar to futures and options in some ways, but have some key differences.
A CFD is a contract between two parties “betting” on the future price of a given asset, for example gold. These two parties are called the buyer and seller. If the CFD’s base asset will be higher in the future than at the contract’s inception, the seller is obliged to pay the buyer the difference between those two prices. Otherwise, if the future price will be lower, it is the buyer who has to pay the difference. In a nutshell, the CFD is about exchanging the difference between entry and exit price so as to take advantage of gold price fluctuations.
The CFD is a relatively new financial instrument. The first CFDs were developed in the early 1990s in London and they were based on equity swaps. They used leverage and were exempt from stamp duty. At the beginning they were used by hedge funds and large institutional investors to hedge the exposure to stocks. A few years later they were introduced to individual investors, who really liked the leverage they offered. Increasing demand caused contracts on other instruments to be introduced; not only stocks, but also indices, bonds, currencies, commodities or gold. In July 2002 the first contract for difference was introduced outside Great Britain in Australia.
CFDs differ from futures contracts in that they are not exchange traded. They are traded directly between their issuer and the buyer. They are not standardized, but although there may be several differences between various contracts, they all share many of the same features.
Buying CFDs doesn’t mean becoming the owner of the gold the contract is based on. They are however linked with gold and reflect its price changes. There are many CFDs on the market including those of very small value. Thanks to them, even small individual investors wanting to invest small amounts of money can get exposure to gold without the need to buy bars or coins.
Similar to futures, contracts for difference offer leverage. It means that they allow for high potential profits, but they also involve a higher risk of suffering bigger losses. Investing in CFDs involves maintaining a margin and just as with futures, topping it up if its value falls below a certain value (called maintenance value). Nevertheless, the required margin is usually lower than for futures.
Contracts for difference differ from options or futures in that they have no expiration date. To close a CFD position one has to enter into a reverse transaction and then the profit is paid out or the loss is realized.
One of their disadvantages is the fact, that buying CFDs involves many fees and commissions, often higher than with options or futures. An example can be the bid-ask spread, overnight fee or management fee. Some of them also charge a so-called daily financing fee, usually based on LIBOR or another interest rate.
Investing in contracts for difference carries several types of risk. One is the market risk. CFDs are an agreement to pay the difference between the entry and exit prices of a given base instrument, like gold, and it is up to gold if this difference is positive and investors profit or negative and they make loss. Another type of risk is the liquidity risk. If there are unfavorable changes in the price of gold the investor may be forced to top up the margin. If he doesn’t do it, the position will be closed and that can mean incurring a loss. The third type of risk is the counterparty risk. Even though the gold prices moves in the desired direction, the other party may not fulfill their obligations and thus make investors lose money. In reality, it is the owner of the company or internet site offering CFDs that is the other side of the transaction. Trading CFDs means then playing against the market regulator which is considered very controversial. Many compare it to a lawsuit where the judge is simultaneously a defendant and a prosecutor.
Contracts for difference can be found in many developed countries around the world, including the UK, Hong Kong, Singapore, New Zealand, Canada, Australia, Ireland, Switzerland, Italy, Germany, France and Poland. They are offered by many brokerage houses and FOREX platforms. They are not available, however, in the United States. This is because of restrictions implemented by the Securities and Exchange Commission (SEC). CFDs, unlike options or futures, can only be bought on the over-the-counter market. The only exception is Australia, where they are listed on an exchange.
The most popular internet services offering CFDs include: