Why trade CFDs?

Contracts for difference trading has taken the planet by storm within the last decade and has gone from being an institutional product to one that is heavily traded by the retail market and fast replacing traditional shares trading as the product of choice for flexible, cost-efficient trading.


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Hedging Exposure on CFDs

But why should you trade CFDs?

CFDs are a really good instrument to use for trading as they allow you to leverage your returns. Buying shares via a traditional stockbroker entails paying the full purchase price, but using a CFD it is possible to create the same exposure with less cash.

CFDs basically allow you to trade most markets from 1% to 10% margin only. This is similar to borrowing to trade and the effect is to magnify potential gains or losses by a factor of 10 (assuming a 10% margin requirement), since a 2% rise in a share price would be the same as a 20% return on your initial outlay. Also, prices follow the underlying stock very closely, in fact, it is hard to see a difference. You do not have to pay capital tax but you do have to pay interest on the loan amount. e.g. if you have bought shares worth 100K, the margin is 5K, but you'll have to pay interest per day on the loan. But it doesn't actually work out to be much.

Long and Short Positions

CFDs also allow you hold both 'long' and 'short' positions. The benefit of this is of course that significant gains can be made both on the way up and on the way down giving you the opportunity to profit in a falling stock market.


Leveraged Returns

Using CFDs a trader can make a significant gain. As an example, let's take Apple stock. Suppose you bought 500 Apple (AAPL) stock at $130 each; you would normally have to spend $65,000 if you were to deal with a traditional stockbroker. If you were then able to sell Apple at $134 you would stand to gain $2000 which is a return of about 3.1%. However, with a contracts for difference you can buy 500 contracts of the stock for a 10% margin or just $6500. This reduced cost is referred to as the CFD initial margin. If the stock rallied in the next few days of trading and you were to sell it at $134 you would still make a profit of $2000, but your return on capital employed is now 30.8%. On the other hand as you might have realised there is also the scope to suffer a significant capital loss if the market moved against your position.

Access thousands of Tradeable Financial Investments

Another great thing about CFDs is that you can easily switch between asset classes. If traders are bearish about the market, they tend to move in to indices and short the index. They switch back to speculating on individual stocks when they're more comfortable with the performance of the equity markets. And not only that. The fall in global Interbank offered rates (Libor) has made margin trading much cheaper than it used to be in the past - for instance holding a long UK stock position held open for less than 7 weeks will typically work out cheaper via a contract for difference than conventional share dealing, although longer holding periods will normally mean that the interest will outweigh the stamp duty saving making the shares the better option.

For myself I like the fact that you can trade any size position with CFDs - however big or small, and I prefer small positions during overnight trades when I am sleeping. And for another, there are no time limits on CFDs. You don't have to worry about missing the expiry date. The index and stock CFDs have no time limits anyway and with commodities the contracts are automatically rolled into the next month. I also like the trading hours and the guaranteed stop order function offered by CFD brokers, which greatly reduces overnight risk. The expanded trading hours are very comfortable compared to the limited hours on the local exchanges. Many underlyings can be traded around the clock so stops can be executed at 3:00 AM if necessary. That helps limit any negative surprises when the markets open.

Contracts for difference are an excellent tool for trading, because of the transparency and easy access.

How do Providers Make Money?

The contracts for difference companies make their money on the interest charged (which is above the base rate obviously) and a slightly bigger spread. They might employ underhand tactics... and market makers may delay winning trades from being filled, I certainly get suspicious sometimes, but if you've got a decent system a small margin of error won't ruin you.

The spread isn't as good as a direct access account, but then you are getting high leverage which means you can do more with it. Also, unlike direct access, you can day trade stocks with it without £25K in the account and although the spreads aren't quite as tight, and you'd never be able to trade UK stocks intraday anyway. Direct access allows you a 50% - 25% margin and will charge you several layers of commission...the brokers commission and the markets commission.

I would say it's a perfect instrument to use for advanced investors or those who have already experienced spread betting and with a lot of good points in comparison to Direct Access. You can also set up stops and limits but often it's not as close to the price as you like on most occasions. It is more for short to medium term trading, days to weeks (or months at a push)... but not too long as the interest will start to mount up. Spread betting only up side is they aren't so draconian about you having to be experienced and they are tax free, but as far as most traders are concerned (the ones that lose) that's not a big thing on their minds.

Also... watch the high gearing stuff! It can be a fast track to profits if you have a good system and experience, if you don't... you will lose a lot of money. Two techniques experienced traders employ to mitigate the risk of big losses is linking any potential loss to the amount of money they are willing to risk the investment capital and having discipline when it comes to the loss one is prepared to accept. For instance, if you have $20,000 of available capital to risk, you should commit no more than 10 per cent or $2000 be committed to each contract. The good thing is, CFD providers don't want you to entirely blow your account as its hard work getting the money back from you, so they may liquidate your holdings if you haven't got the margin for the open position. That normally happens before you turn negative (mostly)... I speak from experience on that. So instead of losing your house, car, job and kids... you just blow your account and maybe have a tenner left out of the ten grand you stuck in there! Good as a learn experience, but a bit pricey.

Shares Versus CFDs Versus Options Versus Warrants

CFDs at a glance -:
  • CFD stands for contract for difference.
  • CFDs also allow investors to speculate on instruments and markets that may otherwise be unavailable or difficult to trade like overseas markets.
  • CFDs allow investors to benefit from the capital gains from a particular stock without having to actually physically own or pay for it.
  • CFDs allow you to participate in the stock market at considerably less cost than via traditional share dealing. This is because CFDs only require a small initial margin as a trading deposit. The leverage allows for the magnification and acceleration of investment returns.
  • You enter into an agreement with a CFD provider - usually a stockbroker or a firm offering an online dealing service - to settle the difference between the price of a particular investment when the agreement is made and its price when the agreement is ended.
  • The profit or loss you make is determined by the difference between the prices at which you buy and sell the contract.
  • You have an interest in the movement of the share's price, but do not buy and hold the actual share itself. In fact, the broker is able to hold the shares. This provides an offset against the contract.
  • Contracts for difference allow you to sell shares that you don't own. This enables you to profit from falling share prices.
  • The investor using CFDs has one key decision to make - do they think the underlying investment is going to go up or down. Get it right and you win; get it wrong and you lose.
  • The low interest rates have made margin trading much cheaper than ever before. Traders only have to pay the London Interbank Offered Rate (Libor) plus 2.5%, which presently works out at just less than 4% per annum.
  • As with spread betting, the amount you lose can be limited with a stop loss.
SUMMARY OF THE FEATURES, RISKS AND TAX TREATMENT OF PRODUCTS AVAILABLE TO THE ADVANCED INVESTOR
Contracts for Difference Covered Warrants Traded Options Spread Betting
Traded on an exchange? No Yes Yes No
Listed on London Stock Exchange? No Yes No No
Loss limited to premium? No Yes Yes* No
Provides gearing? Yes Yes Yes Yes
Broad range of assets available? Yes Yes No Yes
Free of stamp duty? Yes Yes Yes Yes
Exempt from capital gains tax? No No No Yes

*Except certain short positions