A CFD or Contract For Difference is a method that many people use to trade on the financial markets. Essentially it is an agreement between two parties (the “buyer” and the “seller”). The buying party is speculating on the asset price moving upwards while the seller has a position where they want the asset price to decline in value. If the price does in fact go down then the “buyer” of the contract pays the “seller” the difference in the price when the contract is opened and when it is closed. If on the other hand the value goes up then the “seller” is liable to pay the “buyer” the difference.
If you are familiar with the other form of derivative investment – spread betting, then you will find many similarities between the two. Each allow margin trading, stamp duty exemption and the ability to go ‘long’ and ‘short’ (we will discuss each of these in more detail later). CFD trading however does not allow traders to forego paying Capital Gains Tax as spread betting does.
For many years, institutional investors traded CFDs rather than using more traditional investment methods due to the many benefits associated with them. As the general public has become more aware of these benefits, it has become increasingly popular and is a leading form of investment for retail investors in countries such as the UK, Australia and Germany.
What are the advantages of CFD Trading?
Originally introduced in the 1990s as a more cost effective alternative to equity swaps. Not only did they allow trading on margin but they also allowed traders to avoid paying stamp duty on their positions. Traders were therefore better, and more cheaply able to hedge against other investments by ‘short selling’.
The main advantages of CFD trading include:
By being able to trade on ‘margin’, it is possible to open a contract with a value far in excess of the funds you have in your account.
If you wanted to buy £100,000 worth of shares in a company, your stock broker would require you to pay the full £100,000 up front.
CFD companies differ as they will allow you to open a contract worth £100,000 but only require you to put down a small percentage of the contract value. This margin will vary from one company to another and also depending upon the market you are trading in. In some cases you might only be required to trade with 1% of the contract’s value. In the context of a £100,000 share purchase, this means you would only need £1000 in your account to hold a contract worth the same as the more traditional investment alternative.
By their nature, traditional forms of investment such as share or asset purchases only allow you to speculate on their price increasing in value and do not provide you the luxury of being able to ‘bet’ on the price declining.
CFDs, however, put traders in a position where they can speculate on asset prices going either way. If you think a piece of data is going to be released that will adversely affect a share price then you can open a “sell” contract which means if the share price goes down, you will stand to make a profit.
The ability to speculate on falling prices also allows you to hedge against other positions you hold. If you are worried that you are over exposed to a particular financial asset, say gold for example, you could go short using a CFD and protect yourself against excessive losses.
Stamp Duty Exemption
In the UK, if you purchase shares through a stock broker, HMRC requires you to pay stamp duty at a flat rate of 0.5%. Contract For Difference trading is a way of getting around paying this tax which can lead to large savings if you invest substantial amounts or trade frequently.
It can be seen that CFD trading is a useful weapon for any investor to have in their armoury due to the many benefits it allows. It must be mentioned though that due to it being a leveraged product, the trading of Contracts For Difference is also very high risk. Traders can find themselves very rich in a short space of time but can lose equally substantial sums of money just as quickly. To protect yourself from sudden price movements, make sure you open a stop loss on any contracts you open. This stop loss will close out a contract if and when the price of an asset you have an interest in reaches a predetermined point.