CFDs 101

Contracts for Difference (CFD) allow traders to make money from predicting how shares, or other financial instruments, will perform over time.By Hannah Barnaby

CFD are ‘derivatives’ which means they derive their value from movements in the stock market without requiring you to purchase any shares.

In order to do this the investor forms an agreement with a broker – the ‘contract’ – committing to exchange the difference in value of specified shares between the opening and closing of a CFD.

The return you receive at the end of the agreed term depends upon the number of shares included in the contract and the rise or fall in their price.

CFDs can be used predict decreases in share value as well as increases – and margin trading allows the investor to gained magnified exposure to markets, thereby potentially enhancing profits.

‘CFDs can be used predict decreases in share value as well as increases’

If an investor believes the value of a stock will rise, he buys a CFD based on this prediction; this is known as ‘going long’.

Unsurprisingly, predicting that the value of a stock will decline is known as ‘going short’; to do so involves the sale of shares that you don’t actually own in the hope that you can buy them back at a lower price after the stock’s value has declined, thereby making a profit.

CFDs can be used to hedge a traditional stockmarket investment by allowing profits to be made on the CFD even if movements in the market reduce the value of the physical shares.

In common with most investments considered on DIY Investor, CFDs are traded electronically on platforms operated by CFD providers.

Margin Trading

CFD trading allows you to pay a deposit rather than the full price of the contract, which means that you are able to stake a larger position than you would have been able to otherwise; this is also known as gearing and may deliver far greater growth in capital compared to your initial deposit.

If the market moves against you the company will need to be assured that you can cover the full cost of the contract so you may either have to lodge money on account, or have a line of credit agreed with the broker.

‘your capital is not secure and it is a very real possibility that you will lose more than you put into the contract’

However, although your investment can be multiplied using CFD margin trading, you are also at greater risk of losing more than your initial investment if your prediction is incorrect.

When trading CFDs your capital is not secure and it is a very real possibility that you will lose more than you put into the contract; CFD trading is a high risk form of investment only suitable for experienced investors.

Risk

CFD platforms offer tools such as ‘stop loss’ orders which they may charge to include in a contract, but which could minimise the risk of a catastrophic loss by automatically ending a contract if it reaches a specified loss making position.

Choosing a CFD broker is often based upon the risk you are prepared to take and the potential profit you are hoping for and the fees and interest rates it charges.

CFDs in Action

CFDs can be traded with a number of scenarios in mind.

A popular use is to buy a short CFD to hedge against a stockmarket investment; if you are worried that the value of a particular company may fall, a CFD will pay out in that eventuality thereby mitigating the loss in value of the shares.

If you are bullish about the prospects for a particular company, you could buy a long contract to double your exposure to it; your profits could be greatly magnified if you get it right, or you could be left with a substantial debt to pay if you get it wrong – as well as loss of capital on your shares.

Because of the risks associated, your broker should make an assessment about your suitability to trade CFDs.

Charges and Fees

There are various charges and fees associated with investing in CFDs.

At the outset many brokers charge an arrangement fee and it is worth ensuring that your chosen platform is competitive.

If you hold an open contract overnight the broker will charge you interest which is why CFDs tend to be more suitable for very short term trading.

Unlike when spread betting, profits on CFDs attract capital gains tax on profits, although unlike regular shares there is no stamp duty on transactions.

As leveraged products, CFDs can deliver magnified returns based upon volatility in the stock market and offer access to a wide range of investment opportunities; however, they can also incur large losses and so should only be considered with money that you can ‘afford’ or are prepared to lose, and where there is access to finance should losses mount up against you.