CFDs as defined by Wikipedia:

A contract for difference (or CFD) is a contract between two parties, typically described as "buyer" and "seller", stipulating that the seller will pay to the buyer the difference between the current value of an asset and its value at contract time. (If the difference is negative, then the buyer pays instead to the seller.) For example, when applied to equities, such a contract is an equity derivative that allows investors to speculate on share price movements, without the need for ownership of the underlying shares.

CFDs allow investors to take both long or short positions. Unlike futures contracts, CFDs have no fixed expiry date, standardised contract or contract size. Trades are conducted on a leveraged basis with margins typically ranging from 1% to 30% of the notional value for CFDs on leading equities.

CFDs are currently available either unlisted or listed [i.e. mini-warrants and ASX CFDs listed on the Australian Securities Exchange] and/or over-the-counter (OTC) markets in the United Kingdom, The Netherlands, Germany, Switzerland, Italy, Singapore, South Africa, Australia, Canada, New Zealand, Sweden, France, Ireland, Japan and Spain. Some other securities markets, such as Hong Kong, have plans to issue CFDs in the near future. CFDs are not permitted in the United States, due to restrictions by the US Securities and Exchange Commission on OTC financial instruments.

CFDs are a derivative product

CFDs were originally created to imitate traditional share trading, but they differ because you don't actually own the underlying asset, in most cases equity shares. A CFD has no underlying rights on the asset and is simply an agreement between two parties to settle (generally in cash) the difference between the buying and selling price. This means that you can trade on the price movements on an asset without having to physically own it. For example, you can enter into a contract where you buy a CFD on 200 shares of IBM, thereby delivering the same economic outcome instead of having to buy the actual 200 shares on an exchange.

CFDs are a leveraged product

This means that you do not need to fund the entire position, but simply put up a percentage (margin) which is determined by the CFD broker. Leverage enables you to profit significantly if the market moves in the direction that you expect, but at the same time you risk significant losses if the market moves against you.

Simply speaking…

A CFD is similar to something we understand explicitly, that is the purchase of a home using a mortgage. In this transaction you swap asset ownership for finance: The bank provides the finance in the form of your mortgage and in return they take ownership of your home.

Your obligations under the mortgage contract are to meet the monthly instalments which include a capital and finance portion. As long as you continue to perform your obligations under the mortgage contract, you will continue to enjoy the full benefits of home ownership including a roof over your head, rental income, price appreciation etc. If you fail to meet your obligations, the bank will take away your ownership benefits and place the home up for sale. The proceeds from the sale will be offset against the remaining value of the mortgage and the balance will be for the mortgage holder to settle.

CFDs are very similar…

In a CFD transaction, through the finance agreement, in this case a CFD contract, you essentially swap share ownership for finance. Your broker provides the finance in the form of a leveraged CFD position and in return you enjoy the economic benefits of share ownership.

Your obligations under the CFD contract are to meet the capital requirements (margin) and financing costs. The key difference is that, unlike a home mortgage agreement where the periods are monthly, as home prices are far less volatile than share prices, the period and subsequent cash flows are settled daily. As long as you meet these obligations you will receive the full economic benefits of share ownership: that is price appreciation, dividend yield and other corporate action effects. The only exception is that you are not entitled to voting rights associated with share ownership.

However, should you fail to meet your obligation, like the bank, the broker will exercise the right under the CFD contract and place the position up for sale. The proceeds from the sale will be offset against your capital requirements and the balance will be for you to settle.