Why Trade CFDs

What is a CFD (Contract for Difference)?

A CFD - which stands for "contract for difference" - is an agreement to exchange the difference in value of a particular share or index between the time at which a contract is opened and the time at which it is closed. The contract is effectively renewed at the close of each trading day and rolled forward if desired - you can keep your position open indefinitely, providing there is enough margin in your account to support the position.

While the contract remains open, your account with the provider will be debited or credited to reflect interest and dividend adjustments. You can choose to "long" or "short" a position - if you are long, you receive dividends and pay interest, if you are short you do the reverse. Commission is paid on either side of the contract and you can close a contract at any time. In practice there is no minimum contract value though, normally, the smallest contract value will be £10,000.

What are they similar to?

In terms of the derivative's family tree, CFDs sprout from the futures and options branch. The closest cousin to CFDs is spread betting, which works on similar principles in that you are trading on margin and you can go long or short on a position. However, in monetary and experience terms, there is a higher level of barrier to entry for CFDs.

They say... .

"A CFD is a virtual investment on margin," is the way iDealing sums it up. That is, it is a "contract between the provider and its customer to simulate the cashflows an investor would receive or pay if they were buying or selling an actual financial security."

They have been a staple of the institutional market for some years, says IFX Markets, but now they are available to private investors they are "one of the fastest growing financial areas, as more and more individual investors make use of their flexibility". "CFDs are undoubtedly one of the most exciting products available to the retail investor in recent years," adds City Index rather breathlessly.

As iDealing puts it, there are three primary cashflows related to an equity investment - the difference between the purchase and sell price, the dividend (if any) paid while the investment is held, and the interest on the cash required to pay for the stock. "The CFD contractually passes these cashflows to or from the client," adds the company.

"Like other derivatives," says IFX Markets, "they were designed for those investors who wanted to benefit from movements in an underlying asset, but did not need any rights of ownership." As such, you are not entitled to any voting rights - but because you don't own the actual share, it also means you are not liable to pay stamp duty.

According to IG Markets, investing via CFDs gives you access to "thousands of UK, US and world shares on margin with transparent pricing direct from stock exchanges around the world". The standard rate of commission on all this is 0.15%.

But what is margin? Well, as Deal4Free says, it is a "more efficient use of capital because you only have to allocate a small proportion of the value of your position to secure a trade, while still maintaining full exposure on the market". The company summarises this by saying that "in effect, you are able to magnify your return on investment". As Hargreaves Lansdown goes on to explain, "this is called gearing".

Or, as IG Markets puts it, you can open a position without having to put up the full underlying value. "Instead you put up a deposit or margin from just 10% of the contract value (or 5% for limited risk trades)."

Always remember, however, that the obvious corollary to such a leveraged position is that your losses are likewise magnified. As Blue Index says: "CFDs utilise leverage and can be very high risk, so they are only available to clients who have the experience and resources to deal in these type of investments.

"CFD trading is inherently risky and is not appropriate for all investors. You should know how much you potentially can lose and honestly evaluate if you can afford to lose it in view of your financial resources and investment goals."

Hence also the risk protection on offer in the form of stop-loss mechanisms. "If the market moves sharply against you, we guarantee that your position will be closed at your chosen stop level," says IG Markets.

But what of the other benefits? Well, first there is the possibility of going short on a share. "Trading a CFD short is a convenient and cost-effective way of mirroring a potential fall in the underlying share," says Cantor CFDs.

The chance to "pairs trade" is also opened up. "Trading a CFD pair makes it possible for an investor to establish a balanced collateral position while maintaining market sensitivity," says Cantor. "By buying a monetary value of one share, the investor can sell short exactly the same value of another. Being from the same market sector, both shares will typically have a high correlation, which should substantially reduce market risk. The performance of a pairs trade is generally monitored in terms of the ratio of the two stock prices."

We say.. .

As you will by now have gathered, CFDs are not for the faint-hearted. In fact, all providers are obliged by the Financial Services Authority to ascertain from prospective clients that they are well-versed in the arts of trading the markets and have the appropriate experience to enter into the field.

On this basis, it is clear that CFDs are not a product suited to everyone's needs. That they can be a useful weapon in the private investor's armoury is undeniable - they do open up the benefits of ideas such as shorting and gearing and they also come without the cost of the spread.

However, only experienced private investors need apply - as with any form of short-term trading on margin, while the benefits can be huge, so can the losses. Bags of experience and a disciplined trading strategy are essential. As a rough guide, if you are considering using such instruments for the first time, it might be better to look first at using spread betting as the nursery slopes. Alternatively, you can find a plethora of guides and online training programmes on the sites listed opposite.

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