Uses of a CFD

10 things to do with a CFD

1.) Defensive short

There are many reasons why you might continue to own shares that, in an ideal world, you would sell. In the simplest case, you are bullish in the long term, but bearish in the short term.

Alternatively, it could be that you would incur a hefty capital gains tax liability were you to sell. Or you may own a stake in a company through an investment fund, unit trust or company pension scheme. You may even have received equity options from your employer that you cannot yet exercise.

Whatever the reason, if you want to protect yourself from the risk of a short, sharp plunge in assets that you own, then selling a contract for difference (CFD) would protect you from the downside. What you'll need to do is work out your current exposure to a stock, let's say BSkyB. If you own - either directly or indirectly - £5,000-worth of BSkyB shares, and your broker deals CFDs on 10 per cent margins, then you need only sell £500-worth of BSkyB CFDs to neutralise your position.

2.) Gear-Up

CFD brokers have to establish that their clients have enough experience of standard investing before they can open an account. The big reason for this statutory caution is that the margin trading made possible by CFDs allows people to gear-up their investments by up to 100 times.

A typical broker will want you to have a minimum of around £5,000 to open an account, and will offer margin trading of around 10 per cent. With that initial stake, you could buy or sell five CFDs worth £1,000 each - that would represent an exposure in the underlying assets of £10,000 each.

In other words, with £5,000 of initial money at risk, you can reap the upside to £50,000-worth of shares. If you are bullish about stocks or markets, but lack the initial capital - it may be tied up elsewhere - then CFDs allow you to borrow money to invest.

Most CFD brokers will let you gear-up between five and 10 times (offering margin trading of 20 per cent down to 10 per cent). CFDs on indices and currency exchange rates may trade at more aggressive margins of 7.5 per cent. Deal4free is alone in offering new CFD clients margins of as little as 1 per cent. In concrete terms, that means you are borrowing 100 times your initial stake. Even minor changes in the price will result in a massive impact on your profit or loss.

3.) Aggressive short/long

If 'safety first' is not your key motivation, you can just as easily short shares that you do not own. Your thinking may be that a particular share is vulnerable to specific bad news, negative sector sentiment or poor economic data.

Whatever it is, if you think there is a good chance of a small dip in a share price, you can sell a CFD, and its geared effect will amplify the small dip into a sizeable profit. Naturally, the same reasoning works in reverse, if you have good grounds to expect an upward blip in a company's share.

4.) Pairs trading

Royal Dutch Petroleum and Shell Transport & Trading are two halves of the same company. Royal Dutch trades on the Amsterdam Stock Exchange, while Shell trades in London. In theory, their share prices should go up and down in unison.

If a gap develops between the two because Shell rises further than Royal Dutch (lowering the dividend yield), you should feel confident that the anomaly will correct itself sooner or later. In that case, you could sell a Shell CFD and buy a Royal Dutch CFD.

It doesn't matter what happens next in terms of their absolute price movements. Both stocks could soar or collapse - as long as the gap between them narrowed, you would make more money from your long Royal Dutch position than you lost from your short Shell position.

In fact, this possible arbitrage is not as simple as it sounds. Disparities between the two stocks have been shown to persist for years, making this an unsuitable pair for trading CFDs. But it does illustrate the principle.

Another example would be the discount that Schroders' non-voting shares trade at compared with the normal shares. For the past few years, the discount has tended to oscillate between 4 and 12 per cent. CFD traders who speculate on a narrowing discount once it reaches 12 per cent, or a widening discount once it reaches 4 per cent would have made money.

One classic pairs trade used to involve the software stocks Microsoft and SAP. A fall in the dollar would hit earnings at Microsoft, and a rise in the euro would benefit earnings at German-owned SAP.

Pairs trading depends upon individual investors' ability to spot market anomalies, which may persist for years or evaporate overnight. As such, they are hardly ever as free from risk as they first appear.

5.) General hedge

If you have constructed a broad-based portfolio of UK shares that mirrors the FTSE 100, then you can sell index CFDs to hedge your investments. But it's important to bear in mind a couple of points.

First, a broker offering CFDs on indices will normally cover himself by buying or selling FTSE futures. He will add a spread onto the bid and offer prices that he is charged, and pass them onto you. That means that you would often be better off dealing in futures directly.

Second, it's quite rare for a small portfolio to track the FTSE's performance, and there's no reason to make it the goal of your investing strategy. There are plenty of diversified portfolios of UK stocks that are less risky than the FTSE, and offer higher returns (see How you can beat the market, August 2003).

6.) Speculate on sectors

There are few obvious ways to speculate on the UK market's different sectors. Exchange-traded funds (ETFs) would make ideal vehicles, if only there were enough of them. But the costs of putting together an ETF means that they are only offered on the most popular sectors, and only then on a pan-European - or even global - basis.

But there are three CFD brokers that offer products built around FTSE market sectors. City Index, Deal4free and IG Markets all allow investors the chance to buy or sell entire sectors (usually based on all the FTSE 350 stocks in a particular sector, such as the software, pharma or insurance sectors).

For sectors with higher-than-average volatility, or where good news on one stock can boost sentiment across all of its peer group, sector CFDs can offer interesting trading strategies, even when the market as a whole is pretty flat.

7.) Dividend surfing

The whole point behind CFDs is that they are supposed to give you all the advantages of owning shares without the inconveniences (such as paying stamp duty and not being able to go short).

One consequence of this is that, if you own an equity CFD on the day that the underlying share goes ex-dividend, you will be credited with the dividend (less 10 per cent tax). Conversely, if you are short of a company on that day, you will have to cough up the dividend in full.

In theory, this should all come out in the wash and there should be no net difference. The underlying share price should adjust up or down by the amount of the dividend that shareholders are (no longer) entitled to.

But a stock with good momentum behind it may not fall back by the whole amount of the dividend. A CFD trader that jumps in for the dividend, banks it, then bails out before the share price fully settles down, can book a tidy profit.

The ex-dividend date for nearly all shares will fall on a Wednesday, and most CFD brokers will distribute 'week ahead' newsletters to their clients, informing them of all the shares due to go ex-dividend that week.

8.) Save on tax

What you save in stamp duty through CFDs you will eventually lose in financing charges. If the Bank of England continues to raise UK base rates, the interest rate CFD brokers charge you on long positions left open overnight will also increase. That will shorten the window of opportunity.

But it's important to remember that nearly every broker will be flexible on commissions and financing charges, if you can offer big or frequent trades. What's more, if you can increase the margin you trade on from 10 or 20 per cent towards 80 or 90 per cent, there is less reason why the CFD broker should charge you any interest.

In theory, once you're paying an initial margin of 100 per cent (or the whole of the consideration), the broker is not lending you any money, and you should be able to negotiate a truly negligible financing charge.

9.) Save on spreads

By dealing through a company that gives you direct access to Level II prices, you can look at the trades going through the London Stock Exchange's electronic order book (Sets), and specify your own price for your trades. If your price is taken up on Sets, you will have saved yourself the market spread (see CFDs: The basics).

10.) Build up a secret stake

This is not so much a strategy for retail investors as something to watch out for. The two parties to a CFD trade remain anonymous. When the CFD broker hedges his position by buying stock in the market, he is subject to all the usual disclosure rules.

For example, earlier this month, one CFD broker had built up a stake of 15.5 per cent in the office rental company, Regus. But the broker was under no obligation to reveal the identity of his partner in the initial CFD trades.

Perhaps a large number of separate individuals had chosen to trade Regus CFDs through the same broker. Alternatively, it could have been that a few large buyers were using CFDs to exert upwards influence on the share price through covert buying.