A contract for differences (CFD) is an arrangement made in a futures contract whereby differences in the settlement are made through cash payments, rather than by the delivery of physical goods or securities. This is generally an easier method of a settlement because both losses and gains are paid in cash. CFDs provide investors with the all the benefits and risks of owning a security without actually owning it.
If a stock has an asking price of $25.26 and 100 shares are bought at this price, the cost of the transaction is $2,526. With a traditional broker, using a 50% margin, the trade would require at least a $1,263 cash outlay from the trader. With a CFD broker, often only a 5% margin is required, so this trade can be entered for a cash outlay of only $126.30.
It should be noted that when a CFD trade is entered, the position will show a loss equal to the size of the spread. So if the spread is 5 cents with the CFD broker, the stock will need to appreciate 5 cents for the position to be at a breakeven price. If you owned the stock outright, you would be seeing a 5-cent gain, yet you would have paid a commission and have a larger capital outlay. Herein lies the tradeoff.
If the underlying stock were to continue to appreciate and the stock reached a bid price of $25.76, the owned stock can be sold for a $50 gain or $50/$1263=3.95% profit. At the point the underlying stock is at $25.76, the CFD bid price may only be $25.74. Since the trader must exit the CFD trade at the bid price, and the spread in the CFD is likely larger than it is in the actual stock market, a few cents in profit are likely to be given up. Therefore, the CFD gain is an estimated $48 or $48/$126.30=38% return on investment. The CFD may also require the trader to buy at a higher initial price, $25.28 for example. Even so, the $46 to $48 is a real profit from the CFD, whereas the $50 profit from owning the stock does not account for commissions or other fees. In this case, it is likely the CFD put more money in the trader's pocket.