What is a CFD?

A CFD stands for ‘contract for difference’. These are another alternative for frequent share buyers on the stock exchange, and therefore are also involved in the make up of all spread betting sites. A contract for difference means that instead of buying a share and keeping hold of it, the CFD investor comes to a deal with a CFD provider that at the end of the contract, one side of the other will pay the difference between the opening price of the contract and the closing price.

CFDs are a relatively new invention, spanning back to just that start of the 1990s, but currently some 20 percent of the all UK equity deals are now through CFDs. One of the advantages of CFDs on the stock exchange is that they are exempt from stamp duty.

It is possible to trade CFDs on most large UK companies, share price indexes and many foreign companies also. Like spread betting the value does not have to rise in order for a profit to be made, you can take a position on the value of the shares to decrease and you will still take a profit. If you can find someone to agree a deal with you.

So how does a CFD work in practical terms? If you are considering share options and you think that a certain company’s share price will rise over the next few weeks, instead of buying £5,000 worth, where the dealing charge is around 1.5%, added to the cost of stamp duty, and the cost of the underlying stock, which all adds up to more than the £5,000, you can go and trade with a CFD broker. Usually you only have to put up a margin of the stock, say 10% on non-volative shares, and ‘borrow’ the other £4,500 from the CFD provider in return for interest at a pre-set level.

For a week, the arrangement with the CFD provider might cost you only £5. You will almost certainly end up paying some sort of commission on the whole £5,000 but it may be as little as 2% and like spread betting there’s no stamp duty. When the value of the shares rise, you will receive the profit, minus the commission. The important thing to remember though is if your judgement is wrong, you will lose the margin, plus any commission.

Of course you could also use a CFD as a hedging mechanism. Support you are worried about the near-term economic outlook. Let’s say the FTSE 100 is presently trading at 5,500. If you have a £55,000 blue chip shares portfolo you could short 15 FTSE CFDs assuming 1% margin to achieve a complete hedge. 1% of the 5,500 would equal £55 so 15 CFDs would involve you putting in £825 in the CFD account to be able to open the position. Obviously it would be much better if you had a lot more cash deposited at your broker so that you wouldn’t be inadvertently closed out.

Not everywhere in the world

CFDs are not traded in certain countries including the United States. But in Australia and many other countries, you can contact your CFD broker and get involved.

But that’s not to say that CFDs are restricted or unpopular. On the contrary they are widespread around the world and growing markedly in popularity. And there are several reasons why CFDs are popular. Here are just three.

  • Transaction costs are generally lower than with other financial instruments
  • CFDs are simple to understand
  • You can operate on a short selling basis

Now CFDs can be highly leveraged which does raise the possibility of significant gains or losses which means the advice of an experienced CFD broker is a very wise move. As an investor you need to get certain fundamentals spot on.

This involves having a trading plan, knowing both your entry and exit points and being aware of such things as money management and risk management. Again an experienced CFD broker will guide and advise on all these matters.

Once you take the plunge and begin trading in CFDs, you want to be sure your broker provides excellent software which is able to be understood by even a novice trader.  You want the opportunity to trade 24 hours a day and certainly for at least 5 days a week if not more.

There are ways to assist you getting in too deep with software devices enabling you to stop trading when risk management levels are reached. These are automated actions which are designed to safeguard your financial position should things start to head south. This gives added comfort in your quest for profits. Fortunately there are no safeguards should your CFDs start to really produce serious profits.

There are thousands of markets on which you can trade and a wide range of brokers. Start slowly, get plenty of advice and once you do dip your toe in the water, be prepared for an exciting time as you start trading in your CFDs.

Case Study

CFDs attract CGT at the same rate as physical stock but you also receive dividends usually 90% my broker recently paid me 100% on one stock I hold. With CFDs you have a finance charge that is calculated daily on your position the difference between spread bets is that the broker makes his money out of the spread you pay when you open your position. Worldspread were offering 25% margin on AGL but are not offering any stock at present so you can gear yourself 4 to 1 if you chose.

The CFD contract does allow an investor to go long, or short of stock on margins , thereby allowing an investor to multiply gains (or losses) through gearing (because the investor can access to a greater exposure as he pays only a fraction of the total cost of the exposure when he pays a margin which may vary between 10% and 25% generally)

So say an investor has taken an exposure to 1.1 mil shares , but instead of paying 360k , probably paid only say margins of 90k…

If the price falls, he will be asked to pay more margins

For the spread betting company to take that risk on , they must have been happy that the client will have the financial capability to pay up if the price goes against him , but also they must have requested time to accumulate the position to hedge themselves (otherwise how would they be able to pay the investors the difference between the current price, and the price at the time when the investor decides to sell his CFD?

The CFD is in effect a credit transaction trade , whereby the spreadbetting company finances the investor’s trade …

The spreadbetting owns the stocks and voting rights (it is the collateral for the trade)
The investor is liable to CGT , but benefits from (or suffers from) a possible gearing
So in this case it clearly shows in my opinion that the punter has bought and not sold short)

We could speculate that an existing investor, owning some shares, feeling very bullish , but not having any spare cash available at the moment, would sell say 90k‘s worth of shares (for example 270,000 shares or circa 1% of the company), raising thereby enough margin to buy 1.1 mil shares …or 4% of the company (but for the spreadbetting company to do that , they will want to buy 1.1 mil of the stock to cover their risk)

This would be an example of an investor gearing himself up, (with all the dangers that goes with it). Of course it may not be an existing holder, and just someone taking a position on margin (which could still be some gearing (relative his real worth).

CFDs have achieved some fame recently because when you trade on a predicted loss it is the practice known as short-selling. CFDs can be dangerous, because, like spread betting you can lose a lot more than your original stake. Most spread betting companies, like CMC Markets, allow CFD trading, but they are very careful to make sure that you know the risks before you begin, you should make sure you know what you’re doing before you start.

Profits from CFDs are subject to the attentions of Her Majesty’s Revenue and Customs once your £10,100 annual allowance is exhausted. For this reason spread betting is by far the most popular trading product in the United Kingdom market due to the tax status, but do keep in mind that if you incur a spread betting loss this cannot be offset against future tax liabilities whereas it can with contracts for difference.

A CFD, in some circumstances (prior notification), can be turned into a “normal” trade. (in fact there is a normal trade behind most CFD trades. Therefore in effect you can take up stock for the long term. In fact some major investors buy CFDs as a way to building up a stake in a company. Usually, though they are used for short term trading, until the cost of financing outweighs the saving on stamp duty and maybe brokers commission.

Spread betting is just what it says. It is ideal for small punters for obvious reasons, but everyone should be wary of Index options, stock options and Index futures etc. Especially writing them!!!!!

Pros of spread betting – tax free
Pros of CFDs- CGT deduction for interest if you borrow to buy or losses (normally no CGT deduction for interest).
Con of spreads & CFDs – you get charged for holding positions long term.

You have a liking for the capital markets, want to make investments, and also know about CFD trading. You want to get into it as well, but don’t know how? We will work closely with you to find you a CFD broker to facilitate your entry into CFD trading. Find a CFD broker today with us! Our brokers are all experienced and will help you take the right calls in the dynamic markets of today. Whether the markets are bullish or bearish, you can leverage our expertise to leverage your own investments.

Questions to ask your CFD broker: What commission rates is the broker charging – are they charging on the way in and the way out (on buying and selling). What are their financing costs for balances carried?

Remember carefully, if you are paying say 0.5% commission on both transactions (buy and sell) that’s 1%. If say, your trading on a margin of 20% (too dangerous IMO to do less), your broker is earning 5% of your margin deposit. 20 trades a year and he’s earned the equivalent of the entire capital you have put down – Whether your up or down don’t matter to him, he’s charging on the transaction value…

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