A contract for difference (CFD) is an agreement between two parties to exchange, at the close of the contract, the difference between the opening price and the closing price of an underlying share, multiplied by the number of units specified within the contract. CFDs are a particularly valuable tool as investors have the option of selling short and thus profiting from falling share prices.

CFDs work in a similar way to share dealing, except that, although CFDs replicate the price movement of the underlying share, you don’t actually own the physical share as you do in traditional share trading.

Why invest in CFDs?

The increased popularity of CFDs has come about for a number of reasons. CFDs can allow experienced investors to deal in larger amounts than conventional trading, thanks to leverage or gearing. Leverage allows you to multiply your investment, trading larger sized-deals for a smaller outlay than traditional share dealing where normally you have to pay for the entire trade. Unlike traditional share deals, CFDs have the potential to make money when going down as well as when they’re going up. Another advantage is that CFDs have no expiry or settlement date, allowing more flexibility than equity or spread betting trades.

How can CFDs leverage an investment?

Investors only need to put down a fraction of the value of a CFD trade, typically ten per cent, although it can be lower than this for investments with a lot of trading activity, such as market, sector or currency indices.

This means that you can make more, while putting down less money as you can trade often ten, 20 or 30 times the size of your deposit, but of course you can also lose more. Profits or losses can quickly exceed the initial deposit.

Who are CFDs suitable for?

Until recently, CFDs were most commonly used by professional traders, but now private investors are increasingly using CFDs in addition to their existing trading. It is estimated that up to 40 per cent of the daily trades on the London Stock Exchange are now from CFDs compared to ten per cent five years ago, according to research from City Index that was published in April 2006. For UK taxpayers, CFD gains are potentially taxable but individuals are attracted to CFDs because of the possibility of offsetting any losses against gains.

An important point to note is that CFDs are not suitable for all investors and it is a good idea to speak to an independent financial adviser about whether the risks are appropriate for you.

How can CFDs be combined with traditional share dealing to reduce risk?

You can use CFDs to reduce the risk of unexpected market movements. For example, you may have a long-term share holding that you want to keep hold of, but you are worried that it may lose value in the short term. In such circumstances you can take out a CFD that could make money on a drop in the share price and help mitigate the loss on the actual share held. At the same time, this move might assist in making a long-term gain should the share price recover. This technique is called ‘hedging’ the risk and is a major investment strategy often used by experienced investors.

How can CFDs be used to make money when markets go down?

CFDs allow investors to place a ‘short’ on an investment, which means they will make money if a share price or market goes down, allowing investors to profit in a falling market. This is not always possible or convenient with conventional share trading.

What are the tax implications of CFDs?

UK stamp duty does not currently apply to CFDs. This can mean a saving of 0.5 per cent, compared to investing in UK shares. As always, you should be aware that tax laws could change.

If you have a holding of physical shares, you can sell CFDs against this without crystallising a potentially taxable capital gain. This gives you control over the time at which capital gains or losses can be crystallised and may help reduce your tax liability.

Gains on CFDs are potentially subject to capital gains tax and any dividends are liable to income tax at your marginal rate. Are there ways of limiting risk? Where available, investors can use stop losses to automatically close out a position if it falls and thus limit losses.