Benefits of CFD Trading

So what, then, are the principle reasons behind the meteoric rise of CFD trading? The first, and most obvious, factor behind their popularity is the exemption from stamp duty CFD investors enjoy. In Britain, accompanying every standard equity trade, investors must pay a flat rate stamp duty of 0.5%. If a client is trading a CFD, and not the underlying physical share, there is no stamp duty to pay, which adds up to substantial savings when dealing in large volumes. Through the purchase of a £100,000 CFD, investor automatically saves £5,000 over buying the physical shares through the CFD’s stamp duty exception even before other factors are taken into account. Clearly, then, a heavy CFD trader will save considerable amounts of money over trading standard equities.

Dominic Connolly, head of equity research at GNI, is in little doubt that exemption from stamp duty is one of the key drivers behind CFD growth. “People don’t want to pay stamp duty,” he noted. ‘The stamp duty in this country is completely out of line with what the rest of the world pays. We have the highest stamp duty regime in the whole world and 0.5% stamp duty is just not a viable business proposition for an active trader.”

Another highly prized advantage CFDs have over standard equity trading is that CFDs enable clients to short sell stock as well as go long. Short selling shares, or benefiting from a fall in price, has long been the advantage of the bigger institutions. However, CFDs allow individual clients to enjoy the total flexibility the ability to short sell brings.

Darren Sinden, a sales trader at IG Markets, said that the CFDs’ ability to short has opened up a new kind of trading for retail investors. “You’ve now got an extra 50% of directional trading to do as opposed to general trading in a long fashion, which you can mostly do through a local stock broker,” he said. “You’ve suddenly got the other side of the coin to trade on.” He said that before the recent popularity of CFDs, short selling accounted for around 2% of financial bets, but that has now risen to around 25% in the current market. Although this clearly still means that 75% of the business is on the long side, it does represent a significant change in investment patterns, underlying the popularity of CFDs.

The third main area that CFDs have exploited to attract interest is their low costs. The costs of trading CFDs are simply very, very low compared to many other forms of trading. Commissions, where applicable, typically start at only 0.10% and that is obviously very competitive compared to the kind of commissions you pay with the majority of stockbrokers. However, the key issue underlying CFDs’ cost effectiveness is that they are a margin product. This effectively means that you only have to put down 10-20% of the underlying value of that position as collateral.

Simon Daniels, senior equity trader at City Index, points out the practical benefits this offers to clients. “Most of our CFDs are margined at 10% so for every £10,000 of stock that you’re buying you only have to lay out £1,000 on your account here,” he said “This enables day traders to maximise their cash efficiency whilst still trading the market.”

Additionally, the customer is effectively borrowing money from the CFD broker on the long side if they are buying stock but that is lent, again, at a very favourable rate compared to that of a bank. CFD providers will generally charge interest at 3% over base rates, so at the moment about 6.5%. If you try to go to a bank to borrow money to buy shares, firstly they may be reluctant to finance such an enterprise, and secondly, if they did lend you the money it would be likely to be at a significantly higher level than 6.5%.

GNI’s Connolly also pointed out that it is important when explaining CFDs’ recent popularity to not only look at exemption from stamp duty, the ability to go short and leverage, but to look at the growth in the wider context of changes within the dynamics of trade. There are now an increasing number of active traders through the growth of the Internet over the past five or six years and people now simply want to take control over their own financial affairs. Connolly said that the new breed of retail traders are deeply suspicious of the traditional high costs of all financial instruments and funds and of the performance of the TMT and ISA bubbles. CFDs have appealed because of their simplicity as settlement is all through cash so there is no complex paper trail. “People want to take control, they want to make their own trades, and they have access to that now.” Connolly said. “They have access to market information that previously only professionals have and they have access to trading systems and direct market access that was previously unheard of.” Lastly, in turbulent market conditions investors may engage in taking CFD positions to hedge their shareholdings to stabilise investment positions.

CFD Trading Advantages

Trading contracts for difference is one of the most efficient ways of making money from financial instruments. It may be no substitute to buying stocks and bonds for the dyed-in-the-wool buy-and-hold investor who is content to wait for market averages to increase his net worth, but if like most of us you cannot wait for the next boom cycle in order to feel richer, the CFD has many advantages.

One major advantage of the CFD, and perhaps the one it is best known for, is the leveraging of your investment that you are able to do. Leveraging is a way of multiplying the amount you invest in order to make much greater gains than you would from simply buying a stock. CFD’s typically allow you to multiply your funds by a factor of 10 or 20 when you are trading in the markets.

This means that if a stock you are interested in goes up 5%, you do not just get 5% return, as you would if you bought the stock. Instead, if you had 10 to 1 leverage with your CFD, you would achieve a 50% return on your money. Put another way, you need 10 times less money to make the same profit using a CFD rather than buying shares directly. These figures are only approximately correct, as you do have to figure costs into each case.

By using CFDs, you can buy an interest in a share price without actually ever buying the share. It also means that you can control a far greater value of shares that you could using the conventional market, greatly multiplying the amount of your profits. The great thing is that any knowledge and familiarity that you have with shares and their movements can be reapplied using CFDs and your profits accelerated.

Because a CFD is essentially betting on a change in price, it is just as simple to make money from a drop in the share price. Just as when you trade stocks you can “short” a stock, you have the equivalent trade in CFDs which will make money when the price falls. You may even use CFDs to “short” a stock you already hold if you suspect that it is going to lose value in the short run, but do not want to sell it as you believe it will perform well in the longer term. This is an example of using CFDs for hedging your risk.

As your initial investment is multiplied by the leverage available, CFDs are appropriate for short term trading, where you can derive a decent profit from a small move in the price of the underlying security. This means that you do not need a great deal of capital tied up for a long time to make your gains.

But the power of the CFD does not stop there. CFDs are available on a variety of financial instruments, in fact you can buy a contract for difference on virtually anything that you can trade. This includes commodities and foreign exchange, and CFDs are available on indexes and sector groups. As pointed out above, CFDs are very useful for hedging your holdings. In fact, your one CFD account may be used to trade with more than 15 exchanges worldwide. This makes it much easier to diversify your finances, giving you greater flexibility.

Stock index CFDs are available standard products that your broker will trade for you, and while there are similarities between CFDs and futures, the flexibility of CFDs makes them superior for most people. For instance, you can trade CFDs with less money than is required for trading futures, as they are traded in smaller lots. There is no set expiry date for the contract, as with other derivatives, so you can hold CFDs for as long as you like.

Another major advantage with such contracts is the comparatively low costs of trading. The price of trading is low as the broker makes a profit from the spread between the buy and sell price, and some CFD trades do not even have a commission charge. As CFDs count as gambling in the UK, traders using CFDs do not have to pay stamp duty and are not subject to capital gains tax. The only point to watch is that you are effectively borrowing the remaining cost of the shares or commodities from your broker, so you will find that you incur ongoing interest charges. Because of this, CFDs are best viewed as a vehicle for short-term trading which multiplies your profits.

Second only to the Forex market, the CFD market is highly liquid, turning over more than $2 trillion every day. This is despite the fact that you can start with CFDs using as little as $100. For all its size, and the many places it is traded, the Forex market is still estimated to be under $4 trillion each day, and its standard size lots require a larger investment. Contracts for difference truly provide a market where your skill is justly rewarded if you have the education and knowledge to trade them.