Contracts for difference (CFDs) allow investors to speculate on the performance of equities without having to buy a single share. These contracts are an agreement between two parties – the investor and the CFD provider (usually a broker) – that on a set date they will settle the difference between the price of a share on the first day of the contract and its closing price. Instead of physically buying the equity, the CFD holder gets indirect access to its price movements.

They can ‘buy’ or ‘sell’ a CFD, allowing them to take a ‘long’ or ‘short’ position. Effectively they are trading on which direction the share price will go, so using CFDs it is possible to make money from a falling share price.

CFDs are available on many UK, European and US shares, and investors can also use index CFDs, allowing them to speculate on the movement of indices around the world. As CFDs are ‘margin trades’, it is only necessary to pay a margin, or deposit, of as little as 10 per cent of the contract value. This allows a larger position to be taken than would usually be the case. This gearing can translate into much higher profits – or losses.

How do they work?

A CFD share price is the same as the price of the underlying share. Most CFD providers do not add extra pence to a CFD price as sometimes occurs in spread betting or futures trading. If the buy price in the market of a Boots share is 601p, this is the price the CFD will be quoted at.

The following examples demonstrate how CFDs are traded:

Example one

Let us assume an investor is bullish on Boots and thinks the share price will rise. The investor decides to take out a CFD to buy 3,000 Boots shares at 600p each. The total contract value is £18,000, but the investor need only make an initial 10 per cent deposit (margin) payment of £1,800. Also, when buying a CFD there is no stamp duty to pay.

Two weeks later Boots’ shares have risen to 630p and the investor decides to close the contract. The investor gets back the £1,800 deposit plus a gross profit of £900 (30p x 3,000 shares).

Had he or she used the £1,800 to buy Boots’ ordinary shares instead, the profit would have been £90 (30p x 300 shares, a 5 per cent profit) instead of the £900 (50 per cent) achieved by trading the CFD.

Example two

An investor is bearish on Vodafone and believes its share price is about to fall. The investor decides to take out a CFD to sell 15,000 Vodafone shares at 100p each. The total contract value would be £15,000, but again the initial 10 per cent deposit (margin) totals just £1,500.

Two weeks later Vodafone shares have dropped to 95p and the investor decides to close the contract. The investor will receive back the £1,500 deposit plus a gross profit of £750 (5p x 15,000 shares). A 5 per cent fall in the share price has therefore translated into a 50 per cent profit on the initial deposit payment.

In both cases the gearing means similar losses will arise if the price moves against the investor. These examples illustrate the concept of margin trading but they do not take account of commission or the impact of other factors such as financing costs, interest or dividends that may also apply. Although margin trading is potentially more rewarding than an ordinary share deal, it also involves greater risk.

However, it is often possible to use a guaranteed stop loss which allows the contract to close if the price falls – or rises for investors taking a short position – to a specified level.

Why use CFDs?

  • As well as the facility to trade on margin, CFDs offer other benefits to investors. These include: c There is no stamp duty to pay – removing one of the greatest costs when trading shares
  • Investors can go long or short and trade in bull or bear markets
  • You can limit risk – by using guaranteed stop losses on many CFDs
  • You can hedge a portfolio – by using CFDs to hedge against adverse price movements
  • Dealing sizes are small – the minimum as low as one CFD
  • There is extended settlement – as long as the minimum margin requirement is maintained and the financing costs covered, there is no time limit. However, CFDs are designed as short-term plays and interest payments can make it expensive to hold a long position for a long time

How do CFDs compare to similar trading instruments?

CFDs, spread betting and the limited range of universal stock futures (USFs) offered by London’s International Finan-cial Futures Exchange (LIFFE) have a fair amount in common. All are derivatives that allow investors to speculate on the future value of a range of individual shares. All of them are margin products, allowing ‘gearing up’, going short as well as long, and hedging against existing portfolio holdings. Finally, they all have potentially unlimited losses.

However, there are some differences. USFs give investors exposure to a limited number of UK and foreign blue-chip shares, while CFDs are available on a much wider range of stocks. The margins on USFs vary according to price and volatility, but can be lower than for CFDs. The drawbacks are that there are a limited number of USFs – only around 200 are available at the time of writing – and they are less liquid than CFDs.

Spread betting has the big advantage of being exempt from capital gains tax (CGT), although by the same token losses cannot be offset against CGT. Also the difference between the up-bet and down-bet prices on a spread bet tends to be wider than the gap between CFD buy and sell prices.

This gives CFDs a real edge, particularly for very active traders. These small differences in price can add up to a major cost advantage for those looking to take advantage of small movements. CFDs are also more explicitly priced than other types of derivative, with interest and dividend adjustments credited and debited to the trading account, rather than expressed in a changing price.

What sort of investors should consider CFDs?

CFDs are high risk and so are not suitable for everyone, but they can provide a very useful hedging opportunity for sophisticated investors who want to diversify without committing large sums of their portfolio to longer-term or perhaps more illiquid forms of investment. The short-term nature of CFDs and their exemption from stamp duty gives a twist to straight share investment. The caveat is that they are only for those who understand what they could lose as well as what they could gain.

Where are CFDs purchased?

Most brokers now have access to CFDs and so should be able to trade these for an investor very simply.

They are usually issued by broking houses. Again, because the investor is dealing in a CFD, he or she does not physically own the underlying share, which is why the trades are free of stamp duty. The price of the CFD will always exactly track the underlying share price.

What costs are involved?

There are some cost involved in trading CFDs:

  • Interest payments

Clients with a long (buy) CFD position are charged interest on positions held overnight, while interest is paid to clients holding short (sell) CFD positions overnight. Long-trade interest is charged on the amount the broker would have to use to buy the shares, while on a short trade interest is paid on the amount the broker would get for selling the shares. When day-trading CFDs, interest payments should not come into play.

The amount of interest charged tends to be more than the amount the broker will pay the investor. Interest is based on the London Interbank Offered Rate (LIBOR), a series of rates at which banks offer to lend money to each other, compiled by the British Bankers’ Association and published on its website.

CFD providers tend to base the interest they debit and credit to an investor’s account on the very short-term, overnight LIBOR. A broker might, for example, pay LIBOR minus 3 per cent and charge LIBOR plus 3 per cent. If LIBOR stood at 5 per cent, this would mean that on a long position interest would be charged at 8 per cent, and on a short position it would be paid at 2 per cent. The financing rates on CFDs tend to be very attractive when compared against the rates offered on personal loans.

Assuming your broker charges LIBOR plus 3 per cent on long CFD positions held overnight, and that LIBOR stands at 4 per cent, the resulting 7 per cent interest would add up to £700 over a year on a £10,000 contract. But a CFD trader is likely to hold the position open for only a small fraction of that time. Each day the position is open he/she would pay one 365th of £700, or £1.92.

  • Commission

Commission charges vary from broker to broker, but traditionally they are in line with institutional dealing rates of around 0.25 per cent. As with all deals, check if minimum or maximum dealing costs apply, as these affect the costs of trading above or below certain levels.