Contracts for Difference: The basics

The array of spread-betting companies, stockbrokers and futures traders, all competing to offer similar products, but with different charges, commissions and account conditions can be daunting for first-time traders.

So to understand how contracts for difference (contracts for difference) could benefit you, you need to cut a path through all the companies clamouring for your attention and take a look at what sparked off the CFD market in the first place: stamp duty on shares.

We all know that tax distorts the market. And the 0.5 per cent stamp duty on share transactions - which rose as high as 1 per cent in the 1980s - is no exception.

Tax loopholes

It didn't take long after the introduction of stamp duty for City traders to conjure up an interesting way to avoid it. What if two individuals came to a private agreement concerning the future direction of a share price? The parties might agree a contract, such that if the share price rose, Mr A would pay Mr B the difference. And if the share fell, Mr B would pay Mr A the difference. As no shares changed hands, nobody would have to pay stamp duty.

Although it's true that no shares actually change hands between the two parties, anyone offering CFD broking services will want to hedge their exposure. Market makers and other financial intermediaries are in a perfect position to do this, because they are exempt from stamp duty. They can issue a CFD to a client and then buy the underlying stock in the market to cover themselves. And because contracts for differences are 'synthetic' derivatives (created out of other securities), clients can trade on a margin and short the market.

Margin trading

You can buy a CFD that pays out the difference between the price of 10,000 BP shares now (worth £41,600), and 10,000 BP shares in the future. If BP rises by 5 per cent between now and next month, you can sell your CFD at a profit of £2,080 - the difference between £41,600 and £43,680 (ignoring commissions).

But you wouldn't have to cough up the initial stake of £41,600. contracts for difference for major stocks like BP typically trade on a margin of 10-20 per cent, or just £4,160 in our example. Margin trading allows you to gear up your investments, so that by risking an initial stake of £10,000, you can gain exposure to the upside on £100,000-worth of equities.

In fact, some brokers, such as Deal4free, allow margin trading on as little as 1 per cent on FTSE 100 contracts for difference. But remember, whatever your margin is, that's the percentage fall in the underlying asset that would wipe out your stake. On a margin of 1 per cent, your FTSE 100 CFD would only need to fall from 4,320 to 4,277 for you to lose all your cash. If the FTSE fell below 4,277, you would have to pay money into your account to shore up your debts.

Short-selling shares

Aside from gearing, the other big plus of trading contracts for difference is that you can short the market. If you want to speculate on a possible fall in, say, Gallaher, you can sell a CFD. What your CFD broker will do is to borrow Gallaher stock from a long-term institutional investor and promptly sell it. When you close your position in Gallaher, the broker will buy back the stock and credit (or debit) you with the profit (or loss) on the two transactions.

Or at least, that's the way most CFD brokers behave. A few, such as Deal4free, do not hedge their exposure from CFD trades by buying shares. Instead, they balance their exposure by amalgamating all the long and short trades in a stock on their books. Only if it looks like a risky imbalance is developing will Deal4free redress the situation by buying futures contracts.

CFDs used as hedging tools

CFDs are increasingly being used as hedging tools, particularly by people who cannot sell their shares until a specific time period has passed. Say you work for Barclays and you can't exercise your share options for some time. You think Barclays stock is about to hit £6 but when it does it always falls back. So why not put a short on and lock in the price? CFDs are also popular with hedge funds and until sometime ago managers were able to use them to disguise their positions. The most recent example is Polygon Investment Partners, which had quietly built up a 14% stake in clothing chain Peacocks (PEA) using CFDs, prior to its £404 million management buyout.

But thanks to Takeover Panel rule changes introduced a few months ago, anyone who has built up a stake in a company worth 1% or more using derivatives will have to make an announcement to the market.

The change should help private investors and traders keep track of potential short sellers or speculators and following in their footsteps could lead to some juicy profits. For example, many hedge funds made large profits thanks to Phillip Green's aborted attempt to acquire Marks & Spencer (MKS) using CFDs. They bought the CFDs before Green's bid appeared and once the approach become public knowledge, they soon converted them into shares at a significant discount to their rising market price and sold them.

How does such a conversion work? When a client buys a CFD equivalent to, say, 100 shares in any particular company, the CFD provider will buy 100 real, physical shares as a hedge. If the client then wants to convert the CFD to shares, he gives it back to the provider who then hands over the shares in return for a small fee.

The costs

One cost to watch out for is the interest charge that you have to pay to keep a CFD position open overnight.

Remember that if you buy a CFD to reflect a long position of 10,000 BP shares, the broker will normally go and buy those shares in the market. That ties up the broker's capital and he will want to be compensated for that. So regardless of the initial margin you have paid to buy a CFD, you will pay a daily interest rate on the whole of the consideration. .

In our BP example, you would pay around 5.75 per cent a year on a consideration of £41,600 (10,000 BP shares). Divide 5.75 by 365, and you get a daily interest rate of 0.01575 per cent. It's not much but, on a compound basis, it takes just 26 days to reach 0.5 per cent - or the amount in stamp duty you have saved by buying a CFD instead of an equity.

This is why contracts for difference are best thought of as a way to execute short-term trading strategies.

Most CFD brokers specify their interest rates in terms of LIBOR (a close approximation to Bank of England base rates), plus or minus a fixed amount.

If you short a share using a CFD, your broker will sell a consideration of shares in the market and will have cash hanging around. For this reason, you will receive daily interest on short positions.

Typical rates to pay for a long position are LIBOR plus 2 per cent. Expect to receive LIBOR minus 2 per cent when shorting stock. But these rates are negotiable for clients with large amounts of money or high volumes to play with.

The most competitive headline commissions are about 0.2 per cent to trade a CFD on an execution-only basis, or 0.35 per cent as part of an advisory service. Almost every CFD broker we spoke to admitted that headline commissions are negotiable for important clients.

Check your spreads

Because contracts for differences are designed as rapid-fire trading instruments, whether you make money depends a lot on the spreads you're offered. For active traders, spreads can make the difference between dazzling success and pleading with your ex-boss to have your old job back.

One thing that drives people from spread-betting to contracts for difference is that they get fed up with waiting for the share price to move up through the spread before they can even make a penny of profit. This is a factor even though, unlike spread-bet winnings, CFD profits are liable to capital gains tax.

Any serious CFD trader will also need to recognise that not all prices and spreads are the same. The minimum you can expect as a private client is 'best execution', which will add the basic market spread to your costs.

But GNI, IG Markets and now E*trade offer clients direct access to Level II prices. This turns you from a price-taker to a price-maker. For Sets stocks - (thosETraded on the London Stock Exchange's electronic order book - ie, roughly the 200 largest companies by market capitalisation), you can look at the trades going through the market and specify a price for your CFD trade.

In practice, it means you can try to buy at the bid price and sell at the offer price. You will then see your trade appear on Sets. If it is taken up, you will have saved yourself the market spread. In effect, GNI, IG and E*trade are giving up the profit they would normally make on the bid-offer spread and living off the commission instead.

As E*trade is the newest entrant to the direct-access club, it has launched an aggressive campaign to win business from GNI and IG. E*trade is guaranteeing highest commissions of no more than 0.2 per cent or £20. For clients currently paying less than that for direct access trades, E*trade will endeavour to match or better commissions.

Deal4free has a completely different business model. It charges no commission, uses its own prices and makes its own book. This way, it saves money on price feeds, and doesn't tie up capital by physically buying shares (although customers still pay interest daily) .

Other CFD brokers will point out that this allows Deal4free extra leeway in setting its prices. But the company's head of trading, Geoff Langham, is crystal clear about how the prices are set. Every quirk of a share price's movement is tracked by Deal4free. If a stock were to rise and fall 10 per cent within an hour, so would Deal4free's prices. "Everyone sees the same price at the same time," confirms Mr Langham, "and prices are updated every second."

The difference between real market prices and Deal4free's is that the company will take the midway point between the market's bid and offer prices and then add its own spread. For 30 FTSE 100 stocks, the Deal4free spread is as low as 0.25.

The company's business model depends on being able to make up with high volumes what it loses in gross margins.

Range of contracts for difference

Some brokers will stick to the FTSE 250 and only a few will venture as far as small-cap stocks on Aim or Ofex. Only Hargreave Hale says it offers all UK and US stocks, regardless of size. But its commission rate of 1.75 per cent is far higher than anyone else's, so you pay for that extra choice.

Many brokers will demand initial margins of 50 or 60 per cent if the stock is small or illiquid. And it can be hard to short a company with a small free-float because the broker cannot easily borrow stock.

City Index, Deal4free and IG Markets also offer contracts for differences on UK stock market sectors, while IG also offers a unique range of contracts for differences on UK house prices (both national and regional) .