Contract for Difference (CFD)

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A contract for difference, often abbreviated to CFD, is an alternative means by which an individual can invest in a company or asset.

While CFDs are relevant primarily to independent investors, they are also interesting for a company to keep in mind because, in a way, they’re hidden investments. They are affected by share price, but, crucially, do not in turn impact where that price goes.

In our analysis of price to book ratio, we noted that a company’s “market value” is the amount that its stock is selling for on the market (as opposed to “market cap,” which is the total value of its stock). The market value is used as part of the equation that essentially determines if a stock is over- or under-valued. But this isn’t the only reason market value matters to a lot of companies.

The market value can also have a significant impact on companies that depend on outside financing to operate. As one article explaining why companies care if their stocks lose value put it, a company doesn’t necessarily take a direct hit if its stock is sold for a loss. That is, if you buy Apple at $300 and sell it at $250, the company is going to be fine. A smaller company though, without massive reserves of cash on hand, will be impacted if its share prices drop — not least because it will be less attractive to investors or lending companies that take share price into account when evaluating strength and potential.

All of this matters with regard to CFDs because they represent indirect investments that don’t show up in market value. To define them more clearly, CFDs allow people to trade shares of popular stocks (and other assets) without taking possession of those shares. The basic idea is that a CFD represents an investor’s general expectation as to whether a stock will increase or decrease in value. The investor effectively “bets” on or against the share price, and profits if he or she is correct that said price will rise or fall in the allotted period of time. But at no point does the investor buy or sell actual stock — meaning that at no point is the market value affected.

CFDs generally appeal to investors who are looking for simpler ways to trade in the market. There are many such investors out there, which is one reason that mutual funds are still so popular, as well as that low-fee, semi-automated investment apps have become something of a sensation. Investors don’t always want the full responsibility of trading on the day-to-day fluctuations of a share price, so they opt for alternatives that allow them the chance to profit off of the same movements, but with fewer decisions to make.

That’s all well and good, but it can make things more difficult for companies looking to assess their own true strength. While share price indicates the most technical representation of market value at any given moment, it’s possible that a company could also be generating a significant number of buy or sell orders from CFD traders that would speak more to market confidence in the company.

For instance, if Apple is trading at $300, its market value is $300. But if 80% of CFD traders are also “buying” shares in Apple (meaning they’re betting on a rising price), it might suggest, in non-technical terms, that the market’s confidence in the stock is greater than the share price of $300 indicates.