CFD Primer

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An Introduction To CFDs

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 provier 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 and your profits are not subject to capital gains tax. 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.

CFDs have achieved some fame recently because when you trade on a predicted loss it is the practice known as short-selling, which has recently been banned by the government in the wake of the financial crisis. 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.