CFD Survival Guide

Benefits of CFD Trading

Filed under CFDs Education

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.