How Contracts for Differences Pricing Work

Contracts for differences (CFD) agreements are a form of financial derivative sold on some foreign markets. CFDs are not permitted within the United States at this point (August 2010). Therefore, this investment is open only to an investor engaged in a market where CFDs are legal, including the United Kingdom, many European nations and Canada. In a CFD agreement, a "buyer" promises to pay a "seller" the difference between current price and a forward long price, and the "seller" agrees to pay the "buyer" the difference between current price and a forward short price. 

Current Price

The current price on a security is the market value of the security at the time the CFD is arranged. A CFD is typically arranged through a broker, similar to a securities broker, who offers the contracts on the open exchange. The broker matches two parties both desiring a contract at the current price. One party thinks the security will go up in value, and one party thinks the security will go down in value. The broker sets up a contract with a future date, and the parties enter the agreement.

Long Price

When the price of a security rises, it is said to be a long price. The buyer in our example has promised to pay out if the security goes up in price. This buyer would have to pay the difference to the seller, but the security itself would never change hands. The transaction is strictly monetary.

Short Price

If the price of a security drops, it is in a short position. In this case, the seller in our example would have to pay the buyer. Again, no security changes hands, and the transaction is strictly monetary. The seller receives the difference between the price when the CFD was established and its current short position.

Buyers and Sellers

Since there is no actual transaction of securities, the terms buyer and seller are used metaphorically in this contract. The seller is the individual who initiates a contract with a trader, and the buyer is the individual who bites at that contract. However, the two individuals are not buying an asset. Instead, they are buying an opportunity to bid on the price of an asset.

CFD Trade Pricing

Both parties may have to pay a fee to the trader who initiates the transaction. The trader often takes a commission from the "in the money" party at the end of the contract. However, the trader may also take a flat fee for the arranging of the sale and remain uninvolved with the actual transaction. 

Why Are CFDs Illegal?

CFDs are not permitted in the United States because of the way they may potentially manipulate the market arbitrarily. The individuals purchasing these contracts never have a possibility of actually purchasing the security. Even with options and commodities contracts, which are also derivatives in many cases, the buyer always has the potential to actually collect the security. Therefore, the process of buying legal derivatives in the United States is still the process of purchasing assets. The Securities and Exchange Commission bans CFDs because they cannot result in the acquisition of securities in any situation.

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