What is a CFD
A contract for difference is an agreement between two parties, where one party pays the other an amount of money based on a price movement of a security. Neither party has the obligation to buy or deliver the underlying security, the transaction only involves a settlement of the difference of the sale and purchase price.

Speculators can trade CFDs to profit from intra-day, overnight, or longer term price movements in the underlying share. They can also be used to hedge a position in the underlying shares are owned. By taking out a short position for the same value of the underlying share the sale price is effectively locked in, if the share price falls the value of the contract will rise by the same amount. This means that they can be used as a form of insurance or as a part of risk management on an investment portfolio.

How do they work?
CFD's are a leveraged instrument, this means that only a small cash deposit is required as collateral to open a long or short position and this is known as the initial margin. If an investor or speculator was to take out a long position then they will profit from the underlying security increasing in value, if they take the short position then they will profit by the security falling in value.

Risks involved
Because these are highly leveraged instruments a small changes in value of the underlying security will magnify the profit or loss experienced by the CFD holder. So risk management is very important when trading these.

An example below shows the risk involved

If the investor was using a gearing ratio of 10:1 this means that with $5000 of funds, you can buy $50 000 worth of CFDs. If the value of the portfolio was to fall to $45,000 the investor would loose the whole $5000 they had available i.e a 100% loss. If they had purchased $5000 worth of shares and they dropped to $4500 they would have only lost $500 or 10% of their account balance.

Generally when trading CFD's you would not be using 100% of your available funds for trading, have a look at risk management in the left column for more details about protecting your capital.