Essentially an investor can take out a contract for difference using one of three models; Market Maker, Direct Market Access (DMA) or Exchange-Traded CFDs. In the market maker model the CFD provider will quote you with its own price for the underlying financial instrument you are trading on. The way providers cover their exposure by hedging and price feeds makes one important difference between the different models – but also the range of markets covered which is much broader with a market maker.

Trading CFDs with a marker maker means that you are basically a price taker. You don’t see the actual underlying market or the market depth which can be a disadvantage as market depth and volumes are good signals in trading decisions particularly for day traders. Market makers do not always hedge client positions with other counter-parties or in the underlying exchange – which may mean that your provider may benefit if you are on the losing end. On the more positive side market makers are able to offer extra functionality like guaranteed stops (not available on DMA) or quote a much wider range of markets than a DMA broker – and currencies, commodities and indices can only be dealt this way since there is no central exchange.

If your CFD provider operates using the Direct Market Access (DMA) model, then you will be placing your orders directly in the underlying exchange when you take out a contract for difference. This means that the provider will automatically hedge all placed client positions. You can watch the actual underlying market prices and see your order being executed via Level 2. You also get to see other market participants’ orders irrespective if these are buys or sells. So for instance if you want to check a share CFD on the London Stock Exchange you would see the same prices as every trader who trades on the underlying LSE exchange and not just your provider’s price.

Trading via this route makes you a price maker. The real cost of trading without DMA can be hidden as it can be difficult to check the pricing if the spread is unknown or variable. The DMA method is thus more transparent and less subject to abuse than the Market Maker model but on the downside the range of markets offered is quite limited – usually to a limited number of stocks. Because of this if you trade with a market maker, it is still a good idea to check the prices on a DMA platform (which would display the actual market prices) as a reference point to compare against the prices from a market maker (although of course this applies only for markets like stocks that have a central clearing house).

The third method consists of exchange-traded CFDs, which presently are only available in Australia via an authorised broker. These are limited to blue chip stocks like BHP Billiton, Amcor, Woolworths and Wesfarmers. The exchange-traded CFDs model comes at a much lower level of counterparty risk as they utilise the ASX clearing house; the contract for the buyer and the seller is with the clearing house.

IG Markets claims that around 89% of CFD providers are market makers while just 20% offer Direct Market Access. Meanwhile, research from specialist marketing company Investment Trends showed that less than 5% of CFDs are exchange traded.

The first two systems trading are known to as over-the-counter CFDs, where the contract is an arrangement between you and the provider where you are both counterparties to the trade.

Another notable investment strategy, is that because CFDs are a financial product it is also possible to hedge your own portfolio of stocks. If a long-term stockholder is bearish in the medium term of its prospects, they sell an equal and opposite CFD. The benefit there is, if you’re reaping a big gain on your physical stock holding you don’t have to realise that gain by selling the physical stock, and if the price does move downwards then your hedge will protect the value of your holding, because the loss you make on your physical shares will be offset by a gain on the CFD.

Although spread betting offers obvious tax advantages, the visibility and liquidity CFDs offer make them ideal for high volume short-term trades. Both institutional and retail investors are increasingly using CFDs as a vital tool within their portfolio as a complement to the long-term physical stock holding. CFDs are not, and never will be, a substitute for standard equities, but they are simply the most effective method of very short term trading, bar none.

Though they are best known as tools for short-term market speculation, up or down, contracts for difference can also be utilised for taking a trade over months or even years, which is made easier by their lack of an expiry date. CFDs also offer a way way for private investors to hedge existing shareholdings.

Naturally, people have held positions on the long side for a greater length of time than that. One potential reason why someone might hold it for longer may be if they have not got the free capital to take up the contract within the 11-week period. Another key reason why investors may want to hold onto a stock longer than the advised period is because of the flexibility benefit CFDs offer. Often when a position is opened, the investor will not be sure how long they are going to keep it open for. What this means, practically, is that once a position has been opened through a normal share purchase, the 0.5% stamp duty must be paid at once. If the shares are sold before the purchaser anticipated, they cannot recover the financial hit from the initial 0.5%. However, as CFDs operate on an increasing cost scale over time the CFD investor is in a more flexible position to decide when to sell. If a CFD trade goes right after one day than the contract can be sold incurring hardly any costs. If the trade takes longer to reap benefits then at least the CFD trader has had the flexibility to be able to close their position if they had wished to without taking the 0.5% charge.

As City Index’s Daniels notes, one of the major advantages of CFDs can also be construed as a disadvantage. 1t’s exactly the same as your profits. If your profits are magnified your losses are as well,” he pointed out. He went on to say how City Index only allow its CFD products to be used by non private clients, so they’re deemed as experts in the market place. They have to speak to its compliance area and are asked a set of questions to judge their experience of trading. Clearly, CFDs are not for people with a few pounds lying around who fancy a go at playing the markets, the FSA has regulations to ensure only, what was known as expert investors and now known as intermediate customers may trade CFDs. IG Index’s Sinden does point out though those CFD losses can be capped by offering customers a guaranteed stop loss. This means that at the outset of the trade the investor can set their level of maximum risk (usually 10% below the current price) and their exposure will automatically be stopped there no matter how far the share price eventually drops.

Another factor to be aware of with CFDs is that they are an over-the-counter contract and so there is a slightly higher credit risk as you’re relying on an exchange traded product backed by the clearing house. Obviously, this means that an investor’s security depends on the credit worthiness of your provider. The significance of this point is debatable, as it would appear unlikely any major providers of CFDs will collapse, but it is certainly a factor worth considering when comparing CFDs to standard shares.

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.

A CFD is basically an agreement to exchange the difference in value of a financial instrument, such as a share, currency or commodity, between the time at which the contract is opened and the time at which it is closed, enabling an investor to profit (or suffer losses) on the underlying asset without actually owning the share, and enabling the investor to exploit or make losses from downward or upward price movements.

If we take shares as an example, each CFD would correspond to an individual company – such as BP, Rio Tinto or Barclays. It is quoted in exactly the same way, and its movement mirrors the ups and downs of the corresponding share, though with a wider spread, for the reasons explained below. You can buy or sell a CFD whenever you wish and you can choose to hold a position for months or merely a few hours. (CFD trading is regarded as a short term activity due to the financing costs of holding a position open, as CFD providers charge for holding the position overnight).

Unlike shares, you cannot take delivery of a CFD. Instead, you settle the difference between the opening and closing prices, and that difference is your profit or loss (subject to any charges or dividends paid or payable). You will not pay stamp duty (0.5% under current UK legislation) or any safekeeping or nominee charges.

They are useful for traders seeking greater flexibility in maximising profit (though they can also lead to greater losses) as well as hedging risk. CFDs are an efficient means of market participation, keeping costs low, and allowing you the potential to profit on any market movements.

CFDs are tradable using leverage, removing the need to tie up large amounts of capital, and instead trading on margin, an effective way of realizing larger profits from a small initial investment, but can of course lead to even larger losses if the trade is not successful. Trading on margin also involves the risk that if the market moves against you, you face the choice of adding additional funds to the account to cover your margin, or having your position closed out at a loss, leaving you with the obligation to cover any deficit.

‘Just as you prepare for life’s emergencies and sticky situations, professional traders always brace themselves for all market situations. Whether the market goes up or down or sideways, you will still see professional traders in the market – albeit with more focus on risk management and capital protection.’ – Eva Diaz, from her book Real Traders, Real Lives, Real Money

What Are CFDs?

CFDs can essentially be defined as contracts designed to make a short-term profit by reference to movements in the price of a share, but where the underlying share doesn’t change hands. CFDs allow investors to benefit from price movements in a stock without actually needing to own it, a sort of equity derivative. CFDs were introduced into the country in the early 1990s, but it has taken until the last 10 years for them to really capture the imagination. From virtually a standing start, CFDs are estimated to have captured over 30% of the London Stock Exchange trading volume. During a period when traditional stockbrokers are reporting a huge fall in demand, much of the LSE’s upturn is believed to have come from the sustained popularity of CFDs and spread betting.

A contract for difference (CFD) is essentially an agreement between two entities to exchange the difference in price between the opening and closing price of a contract that is based on the price of an underlying instrument (such as a share price). The profit or loss is determined by the difference between the two prices at which the contract is bought or sold. In essence, the CFD broker agrees that if the trade shows a profit the provider will pay this amount to the trader. If the trade is a loser, the trader pays the difference to the CFD broker. Hence the term ‘contract for difference’. In return for the provision of this service, the CFD provider charges interest on the money ‘lent’ to you to buy on margin, and pays you interest on any short positions. Interest calculations need to be taken into account on bought, or long, positions, because interest is calculated on any positions held overnight. Interest is calculated at the full face value of the position, and not just on the amount of margin you have used.

The contract for difference (CFD) business is booming: Analysts in the 2010 UK Financial Spread Betting and Contracts for Difference Report stated they expected an additional 9,000 CFD traders to enter the market in 2011. Additionally, a study by consultancy Tabb Group, Breaking Down the UK Equity Market, written by analysts Miranda Mizen and Will Rhode and published earlier this year, found that about €1.3 trillion ($1.8 trillion) of UK turnover is related to CFDs, accounting for 31 percent of total equity turnover, or half the executable market.

Both CFDs and Spread Betting share similar characteristics, so how should investors decide whether they want to trade them, and choose between the two?

Both products allow the user to go ‘short’ i.e. sell, and also, being margined products, both can utilise leverage. However there are significant differences between CFDs and Spread Betting, and knowing the differences will help a trader determine whether one, both, or neither is right for them.

Essentially a CFD mimics every aspect of owning the underlying share or market without actually doing so. This has a number of advantages, but also some disadvantages.

The cost of financing a CFD position, such as commission, is not wrapped inside the spread, but is charged separately. Because of this, the CFD spread quote should always reflect the underlying price of the share or commodity you are following, as they wrap their spread around the market price. The spread from a spread betting firm however, is set by the firm in a similar way to a bookmaker, at a ‘take it or leave it’ price. This means that a CFD price is often much more transparent than a spread betting price, and takes away the ability for a firm to keep changing the spread or moving the goal posts solely to suit themselves.

This approach also means that some CFD providers and platforms offer Direct Market Access (DMA). This is an electronic trading facility that allows CFD investors a way to interact directly with the order book of an exchange, missing out the market maker. This gives the trader more control and is often combined with algorithmic, or ‘robot’, trading, to give access to many different trading strategies.

The bid-offer spread is often the most significant cost of trading. Controlling this cost is why hedge funds often use CFDs and not spread-bets, as the market controls the spread and not the company, so access to the market through CFDs means access to real prices. With spread betting, when the trader wants to exit the trade they may find himself disadvantaged by dealing with a counterparty that not only knows his position, but can quote a price that could potentially suit the company more than the individual trying to close the trade.

When trading CFDs, contracts are purchased in a similar way to purchasing shares. If you wanted to buy, say, 1,000 shares of an oil company, and did not want to buy these as a physical shareholding, you would buy those 1,000 shares through a contract at the price and then wait for the price to move. By contrast, with a spread bet you would place a certain amount; say £10 per point, bet on the price movement of the oil company. This means you are looking for how much the price moves more than what price it moves to.

The currency in which you place bets is another key distinction between CFDs and spread bets. With CFDs, your bet will be denominated in the currency of the underlying asset. So, if you are buying a Gold CFD, your position will be valued in dollars. If you are buying the Nikkei 225 it will be in Japanese Yen. This creates the inherent risk or potential reward that falling or rising currency rates will reduce your profits or magnify your losses. As spread betting uses synthetic prices, you will trade in Sterling in the UK, or Euros in Europe, using your home currency rather than relying on currency conversion prices.

Some CFD firms also offer advisory services, of which there are very few in spread betting. If you opt for an advisory account with a CFD firm, your broker can provide you with recommendations on what to buy or sell, which can help many market participants, though there is no guarantee an advisor’s performance will be more profitable. You should also bear in mind that advisory services will generally cost more in terms of commission or charges then trading execution only.

The structure of the market means that CFD traders usually have much greater resources than spread betting customers. This is because traders who want to take bigger positions want to be assured of getting their orders filled at a particular price. With spread betting, this is much harder, as the prices are merely derived from the market, rather than set by it. On big orders this makes a significant difference to serious investors.

Another difference between the two is that Capital Gains Tax is due on CFDs and not Spread Betting, which could add some extra cost to CFDs, although some traders would say that it is the cost of the approach they wish to take. A lot of investors also use CFDs for hedging purposes because they are liable for capital gains tax. This means they can be used to offset against taxable returns on previous years.

Trading CFDs or Spread betting is riskier than trading equities or other financial products, they are not suitable investments for everyone and are designed for traders with sufficient experience of the markets to understand the products and underlying investments they are trading on. Whilst both instruments enable traders to access greater flexibility and potential profit than other less risky products, the higher degree of risk can generate large losses in a short space of time. If you are considering trading either product, you should make sure you fully understand all the risks involved before you begin trading, and should only invest money you can afford to lose.

The rise in the trade of contracts for difference, or CFDs, over recent years has been extremely rapid; their exception from stamp duty, ability to offer retail investors the option to short, and their relative low cost to trade means that, despite the popularity of spread betting, CFDs would appear to be the ideal short term investment tool.

Another reason trading CFDs are considered a more productive short term trading tool than a spread bet is because spread bets are essentially futures based products and the pricing is certainly opaque compared to CFDs. IG Index’s Sinden said that essentially with a spread bet you are taking somebody else’s price because futures based prices estimate future interest rates and dividend flows, they will provide a two-way price and the customer is obliged to accept that. A CFD ignores those two elements and treats them as a separate item, therefore accurately reflecting the prices in the market at any given time. Hedge funds, as a rule, do not spread bet. The reason being that they see the bid offer spread is a very significant, if not the most significant, cost of trading. Hedge funds use CFDs because visibility and an accurate reflection of market prices is a key trading efficiency factor. Every time you deal you have to cross the bid offer spread and for heavy traders a small change in their trading efficiency could have a large impact on their financial success.

Note: I don’t really like spread betting. Because of the spreads and sometimes the restriction on opening trades. CFDs is just like trading on the market so if you have the right providers/platform then you should be able to deal just as keenly. Having said that UK residents might do well to consider spreadbets due to the tax-free aspect. Also you would normally need more money to trade CFDs.

CFDs allow investors and traders to gain economic exposure to a wide range of financial assets without having to take physical ownership of the underlying asset. To bring the range of markets into perspective, IG Markets, for instance allows you to trade over 8,000 worldwide equities, indices, commodities and currency pairs. Clients also have the ability to trade long or short depending on whether they believe an asset’s price will rise or fall.

You see, contracts for differences allow private investors to speculate on the difference (‘mind the gap’) between the price of something today and the price of it tomorrow, or next week, or the next month.

As one of the world’s fastest-growing trading products, CFDs are very simple and relatively inexpensive to trade, and are more flexible than other trading alternatives. CFDs also suit diverse trading strategies, and can complement your existing investing methods. You can also speculate on a market rising or falling in price and CFDs allow you to trade in a very wide range of instruments such as shares, indices, commodities and currencies.

CFDs were originally created to imitate traditional share trading, but they differ because the investor doesn’t actually own the share; it is a derivative product. So an investor or trader can seek to gain from price fluctuations without putting down large amounts of capital. They provide the opportunity to make profits (or losses) from a wide range of markets including shares, indices, foreign exchange, interest rates and commodities.

For starters, CFDs are leveraged trading instruments. Leverage allows traders and investors to potentially multiply their investment; trading larger sizes for a smaller outlay than conventional share dealing where normally you have to pay for the entire trade. This means that experienced investors are able to deal in bigger sizes than conventional trading when utilising leverage. The advantage of a smaller outlay, as well as the opportunity to gain from rising and falling markets (assuming you have traded in the right direction) translate into an exciting new trading product, which is widely considered a smarter alternative to physical share trading. Another key attraction of trading with CFDs is that they can be utlised with great effect to take advantage of a developing trading pattern in the market.

• Easy to trade and understand – this is especially true if you have experience in trading shares as the same processes apply. For example, if your share price is $5.00, the CFD price will be $5.00. The only difference is that you will be trading on the price of a share that you don’t actually own.
• Cost effective – although there are risks involved, like any other investment, opening up an account in which to trade CFDs is minimal with some providers charging as little as 1% margin. It is therefore possible to make profit on a small investment.
• Trades can be long or short – an attractive option with a CFD is that you can trade long by gaining profit from prices going up, or trade short and profit on prices going down.
• No expiry – unlike other derivatives, there is no set length of time that you can hold a CFD for. You can hold it for as long or short a time as you wish to. However, it is always important that you set yourself goals before you trade as to not overstretch your investments.

A short sale is a trading technique where a trader borrows a stock (or commodity futures contract) from a broker and sells it, with the condition that it must be later bought back (the trader hopes to buy it back at a lower price) and returned to the broker. Short selling (or ‘selling short’) is a technique utilised by CFD traders who try to profit from the falling price of a stock.

Further CFD Expansion

Despite a slowdown of growth in the retail sector from its breakneck rate of two years ago, IG Markets is still opening thousands of new CFD accounts a month. The introduction of Direct Market Access coupled with the new abilities CFDs gave retail investors triggered extremely strong growth. However, CFDs are not only for the benefit of retail investors, as there is also sustained growth in institutional customers taking advantages of the benefits CFDs offer, partly because of the recent growth of hedge funds.

The range of CFD products has also expanded dramatically since their inception. For instance, IG Markets currently trades CFDs on the FTSE 100, 250 & 350 stocks and also do most liquid shares with a market cap of above £25m. In the US they do everything in the S&P 500, all the Nasdaq 100 and most other composite stocks that are at least as large as the smallest Nasdaq 100, stock roughly $1bn market cap. The company also offers many continental European products and selected Japanese and Australian CFDs.

For knowledgeable investors, CFDs offer a quick, flexible and cost effective way to speculate on whether an investment will go up or down.

Please note that may not be suitable for all investors, so please be aware of the risks.

Limit Order

A Limit Order consists of an order placed outside of the present market bid or offer price. For instance, if the present offer price for Apple CFDs is $150 and you would like to sell them at a higher price, say $153.50, you can put an order to sell your stock CFDs at a limit price of $153.50. Should the price reach your limit price, your order will be normally executed. However, in situations where there is an insufficient quantity available at your limit price, your order may not be executed (or you may receive a partial fill if trading with a direct market access broker). In such a circumstance, your order will part-fill and your residual order will remain open at your limit price.

Stop Loss Order

Stop Loss Order – an effective way to manage your risk is with a stop loss order which will take you out of a trade when the price of a CFD moves against you. This tool is easily used through your online account and should help to marginalise risk.

Guaranteed Stop-Loss Order (GSLO)

There is another type of stop-loss order that guarantees your exit price despite price gaps.

You have a long trade on ABC stock CFD for 10,000 shares and you have already made some unrealised profits. You don’t want to close the trade but you have to be away on a holiday. You decided to put a Guaranteed Stop-Loss Order to protect your profit and to ensure any losses will be limited:

ABC stock CFD price = $5.00
Long position of 10,000
GSLO set at 5% of CFD price = GSLO set at $4.75
Price goes to $4.20 while you were away
GSLO would have you taken out at $4.75 even if it reached $4.20.

Market Order

A Market Order is a type of CFD order placed and executed at the current market price. Your gain or loss on the trade depends on the rise and fall of the market.

A Stop-Loss Order consists of an order placed with the aim of capping the potential loss of an open trade. When triggered the stop loss order closes out the trade at the designated price level and prevents the possibility of losses to continue accumulating in the process. Please note that normal stop loss orders are not guaranteed and in certain (rare) situations the market may rapidly fall before the order can be executed leaving your original position open.

Conditional Order

Conditional Orders is all about anticipating potential losses and liabilities before they bite you and taking steps just in case they do. One popular conditional order is the ‘OCO’ which stands for ‘One cancels the other’. You can even link an ‘if done’ order to an OCO to automate the profit taking process. This involves you placing two orders in the market in such a way that if one gets triggered the other order is automatically cancelled thereby allowing you to both input a stop order and a limit order at the same time. If the market rises and hits your limit price your CFD trade would be closed at a gain, with the OCO cancelling the stop order – in this way avoiding the risk of the market turning and triggering a new short trade.

One Cancels the Other – this is a type of order which can link two separate trades. Usually it is an order linked to a stop order.

If Done Order – similar to an OCO order but it links two orders together and when the first is carried out, the second is automatically done too.

Here is a trading plan for a CFD trade which includes more strategy orders than most CFD traders would consider for multiple positions -:

A investor is monitoring the February Brent Crude Oil future contract which is presently hovering at the $85 price per barrel. The crude oil price has been rising in the last few months but the trader is still confident that the oil price will keep rising although he believes that there is the possibility of a short-term retracement to $80 before the rise continues. Having checked the charts in detail, the trader reckons that the price could well climb to the $97 level before finding strong resistance. However, he’s concerned that a pullback to $76 might lead to a further fallback to $66 and he doesn’t want to keep the trade open should that scenario materialise. The trader could place the following order:

Buy £10 of February Brent Crude Oil at a limit price of $80.00 If done, sell £10 at $97.00 limit, OCO $76.00 on stop – all GTC (good till cancelled).

This strategy includes a limit, stop, contingent order and an OCO – all worked ‘GTC’ (good till cancelled). The setup includes a limit order to open a trade should the oil price pullback to $80. Contingent to this order being executed there is a limit order to close the trade at a profit should the oil price hit $97. Moreover, there is also a linked contingent stop to close the position if the market moves against the speculator and hit $76. This will protect the trader against losses continuing to accumulate should the market keep moving in the opposite direction to the original trade. This combination of orders represents an OCO order: if the limit order of $97 were reached first, then the stop loss at $76 would be automatically cancelled.

This is a very good risk management tool in situations where your limit order is executed and you are away from your desk, because you already have appropriate protection mechanisms in place.

CFDs can be placed on a vast range of global financial markets including domestic and global shares, indices, interest rates, forex pairs (forex or FX), and commodities such as gold and oil using a single trading account.

CFDs have no fixed expiry date, so investors have even more flexibility than futures or options. CFDs are normally used for short term trading but like other investment products, the utilities of CFDs vary depending on an investor’s individual circumstances and investment time-horizon. It is worth noting that the CFD trading market is growing rapidly and is now not just restricted to professional investors.

Contracts for Differences are nowadays widely used by private investors as well as fund managers and trading companies, and their success all over the globe demonstrates how useful they can be. CFDs will always be a specialised and focused tool to help hedge a portfolio against systematic risks.

How can CFDs leverage an investment?

Using contracts for differences investors need only put down a fraction of the total value of a trade. This is typically 10% (and lower than this for the more widely traded markets such as forex pairs trading); this means that investors can potentially make more, whilst putting down less money as they can trade often 10 or 20 times (and probably much more but leveraging yourself to the tilt is not recommended!) the size of their deposit; but of course they can also lose more. Profits or losses can quickly exceed the initial capital outlay.

Leverage allows an investor to outlay a smaller amount than is normally required to invest in world markets.

This means that with CFDs there is no need to make a large initial outlay to get started. That’s because rather than buying the stocks outright, you simply put a deposit on them. Of course it is recommended that you are adequately capitalised.

For instance, if you were to purchase a CFD over Vodafone shares the deposit required might be just 5% of the value of the trade. This deposit is referred to as initial margin in financial markets terms. So if Vodafone is trading at 167p a share and you wanted to buy 10,000 shares it works out something like this: £1.67 x 10,000 x 5% = £835. So only £835 would be needed to open this position rather than £16,700 to purchase the Vodafone shares outright. You still enjoy the possible gains in owning 10,000 Vodafone shares as if you owned them outright.

Are there any disadvantages to holding a CFD rather than a share?

You don’t get a say in the company’s operations; for instance CFD holders don’t get an invite to the company’s annual meeting, or get to vote on shareholder issues because with a contract for difference you do not own the underlying securities.

How can CFDs be used to make money when markets go down?

Another trading strategy made possible with CFD trading is shorting which gives investors the capacity to profit from falling markets. Using CFDs investors are able to open up a ‘short’ position on a financial instrument (investment), which in practice means they may make money if a stock price or market goes down. This allows traders and investors to gain in a falling market. Shorting in effect means to sell something that you don’t currently own, knowing that at some point in the future you will have to buy the same quantity back. To make a gain in the financial markets you can either ‘buy low and sell high’ or ‘sell high and buy low’. If you sell something at a high price and then manage to buy it back at a lower price, then the difference makes up your profit. It is a strategy often used by more sophisticated investors that either believe the market is going down or as part of a hedging strategy.

Shorting is very difficult to do with conventional share trading. The risk of shorting is that the price of the market you’re trading rises, meaning a loss that could even exceed your initial investment.

How can CFDs be combined with traditional share dealing to reduce risk?

Investors can utilise CFDs to hedge against adverse market movements. Let’s say you owned banking stocks and feared that they would fall in value but didn’t want to sell; you could enter a short CFD trade in the same stock to temporarily neutralise that position. The advantage here is that you are utilising leverage so you don’t need so much capital to setup the hedge.

Hedging isn’t limited to individual shares either. For instance, you may own a portfolio of FTSE 100 blue-chip share investments that you wish to continue holding but you are worried that in the short term the investment might lose some value because you believe the share markets are heading down. You can take out a short contract for difference contract so as to profit from a drop in the share price and thereby in this way help offset any losses incurred on the physical holdings. To protect your position, you could sell a FTSE 100 Index CFD against this position to minimise losses if the market subsequently falls. As your share investments lose value, your CFD position becomes profitable. This investment strategy is largely referred to as ‘hedging’ your risk and is commonly utilised by experienced investors alongside their shares portfolios.

Example: Let’s say the FTSE 100 is presently trading at 5,600. An investor with a diversified portfolio of blue chip shares worth £100,000 could ‘protect’ his positions by setting up a short on the corresponding index CFD. Assuming a single index CFD is equivalent to an exposure of a pound a point the investor would need to short 18 contracts to cover his investment. Assuming a margin requirement of 2%, one would need £2,000 to establish this hedge (plus extra funds to cover running losses). There would also be the overnight financing fee of about £6 each day the position is kept open.

Note that hedging is just a way of protecting an investment against downside loss by making balancing or opposing contracts or transactions with another investment. In other words with hedging you are trying to minimize unexpected movements against your position.

What are the trading costs and commissions?

Most DMA CFD providers will mirror the prices of the underlying market so the bid-offer spread will normally be very close (if not the same) as if you were buying the shares directly. In such cases the provider will then charge a commission on the transaction. The amount of this commission differs between providers but is typically computed at 0.1% of the market exposure on the buy and sell side, subject to a minimum charge of £8 or £10. Market Makers on the other hand might add a fixed percentage spread on the bid and offer prices of the market instrument without charging direct commission. The other cost you have to take into account is the financing fee which is debited daily on rolling overnight positions. This reflects the fact that you are effectively borrowing most of the funding for the position from the provider.

What are the tax implications of CFDs?

UK stamp duty does not currently apply to CFDs. This can mean a saving of 0.5 per cent, for example in the case of CFDs referenced to UK shares. As
always, investors should be aware that tax laws can change.

If an investor has a holding of physical shares they can sell CFDs against this, without crystallising a potentially taxable capital gain. This gives the investor control over the time at which capital gains or losses can be crystallised and may help reduce their tax liability.

It has to be noted that CFDs profits are taxable, but active traders and investors are especially attracted to contracts for differences because of the possibility of offsetting losses against tax on any gains.

What are the benefits and risks?

With CFDs being a leveraged product, the benefit should be clear – even relatively modest gains in a stock or commodiity you are trading in can translate into much larger returns than you’d get from other investment products. The risk is that of course this also works in reverse; small losses will also be magnified, resulting in bigger losses than other investment products, including the risk of you losing more than your initial investment. If you are just starting out it is recommended that you utilise leverage conservatively.

What is DMA Access and what are the advantages of trading DMA?

DMA access allows investors and traders to place their buy and sell orders on the central limit order book of the stock exchange. This enables them to trade SETS and SETSmm stocks directly with other market participants, rather than having to go via a market maker and pay their spread. In particular, this is especially valuable when combined with Level 2 prices which allows you the ability to see all the outstanding orders on the actual order book including the volumes of buy and sell orders which make up the supply and demand for a stock. If a share is trading at 184p-188p, an investor using traditional broker would have to cross the spread by buying at the offer of 188p and selling at the bid of 184p. On a round trip trade of 10,000 shares this would cost £400. A DMA CFD trader who was looking to buy could try and improve on the price by entering their own quote inside this spread. This would join the best priced orders at the top of the book and would stand a good possibility of being executed. Other advantages of DMA access i that is allows participating in an exchange opening and closing auctions.

Traders commonly keep an eye on Level 2 by checking the the total number of shares on the bid and offer sides of the book so as to have an idea of the overall levels of supply and demand of a stock. Direct Market Access also allows investors to participate in an exchange’s opening and closing auctions which is when a stock is most likely to reach its high or low point of the day meaning that those with DMA have the possibility to get filled at the very best prices.

Are there ways of limiting risk?

CFDs can be placed on a vast range of global financial markets including stocks, indices, commodities, interest rates and forex pairs.

Where available, investors and traders can utilise stop loss orders to automatically close out a trade if it falls and thus cap losses.

How can you use CFDs as a hedging mechanism?

Being able to go long and short and to leverage trades makes contracts for difference a good tool for executing hedging strategies. If an investor has a physical portfolio of shares he believes could take a hit in coming weeks, he could hedge that risk by taking an opposing position with a CFD.

Let’s suppose it is the last week in January and an investor holds a portfolio of blue-chip stocks worth about £60,000. The FTSE is trading at about 6,000. For capital gains tax purposes the investor would prefer not to sell his shares until the new tax year in April, but is still concerned that his portfolio would fall in the meantime because of widespread troubles in North Africa.

The investor would need to short 10 FTSE 100 CFDs to hedge his market exposure (or alternatively he may opt for a partial hedge). The initial margin requirement is usually 1% so with the FTSE 100 trading at 6,000 each CFD would need an initial deposit of £60. Thus the investor would need about £600 to open the CFD hedge and a few more thousands in cash reserves to cover any losses.

On the 10th of March, the FTSE falls nearly 8% to around 5,520 and the drop has wiped about £4,800 off his stock portfolio. The CFD has moved 480 points in his favour, earning him the equivalent of his shares portfolio loss on that trade. For only a nominal amount (financing fees), he has bought himself an almost perfect (short-term) hedge.

So basically you take a position opposite to your physical holding and wait until the crisis and market volatility have subsided. In this respect it is preservation strategy rather than a way of making money. This hedging system works best in the short term, for instance if an investor owns a portfolio of stocks he believes could fall in the near but would rather not sell, perhaps because the new tax year is approaching and he wants to defer any CGT liability to that coming period. In this case he could short the same shares with a contract for difference, utilising leverage to achieve the same exposure. Any losses incurred on the shares portfolio due to the adverse market conditions would be offset by the profit on the CFD.

Do you recommend any particular CFD providers?

CFD providers are a bit like banks – most offer a satisfactory service, however some are only market makers while others also offer DMA Access.

I like IG Markets as they offer both a quote-driven service (market maker) as well as the ability to trade directly on the exchange (DMA Access) so in effect they offer the best of both worlds. IG Markets quote over 8000 global share CFDs from the world’s top exchanges, as well indices including the Singapore Blue Chip, Japan All-Share, Hong Kong HS34, India 50, Korea KOSPI 200, Taiwan All-Share, China H-Shares, Australia 200, FTSE 100, FTSE 250, Wall Street, USA S&P 500 and Nasdaq; Germany DAX 30, France CAC 40 and other European indices. I also like the fact that IG Markets are themselves a FTSE 250 public limited company and thus quoted on the London Stock Exchange.

Here are some additional benefits of using IG Markets as a CFD provider -:

• Live real-market tradeable prices using Direct Market Access (DMA) functionality, ensuring your share CFD orders go straight into the underlying exchange.
• Live news and charting.
• Participate in share market price auctions – both open and closing market price auctions.
• Real Market Depth is available on all instruments online, allowing clients to view, in real-time, exactly what prices and volumes are available.
• Multiple order types with market alerts including Market, Stop Entry, Stop Exit, Limits, Iceberg and GTC.
• Customisable trading platform.

Contracts for Difference, or CFDs for short are financial instruments where the buyer receives or pays to the seller the difference in a company’s share price over time, giving the holder an economic interest in the company but no direct ownership of its stock.

GUIDE to CFDS

As technology improves, so does the way that you are able to invest and manage your money. There are now many aspects of the investment world in which you can actively trade in, not just shares.

In fact there are various types of CFDs. They include share CFDs, index CFDs, sector CFDs, FX CFDs, CFDs on commodities and CFDs on international shares. In addition to UK and Australian shares, most providers now also offer International share CFDs including US, European, and Asian shares. This means you can trade share CFDs on Google, Apple, Amazon, Wal-Mart, Honda, Toyota, Vodafone, BMW, British Airways and other big brands that may not available in the local market.

What are CFDs and how do they Work?

A contract for difference or CFD as it is commonly referred to is a contract between two parties, typically described as ‘buyer’ and ‘seller’, stipulating that the seller will pay to the buyer the difference between the current value of an asset and its value at contract time. (if the difference is negative, then the buyer pays instead to the seller). In effect, CFDs are financial derivatives that allow investors to take advantage of prices moving up (long positions) or prices moving down (short positions) on underlying financial instruments and are often used to speculate on those markets.

In essence, a contract for difference consists of an agreement or contract between two parties (for example, you and the CFD provider) to exchange the difference in value between the opening and closing price of a particular financial product, such as a share.

When you trade CFDs, you take a position on the change in value of the underlying asset between the moment the contract is opened and the time it is closed. You are essentially speculating on whether the value of an underlying asset is going to rise or fall in the future compared to what it was when the contract was taken out (or executed). In other words, CFD trading is opened at a specific prevailing market price and closed at the reigning market price and the client is entitled to the difference.

For example, when applied to shares, such a contract is an equity derivative that allows investors to speculate on share price movements, without the need for ownership of the underlying shares.

Major banks and hedge funds utilise contracts for differences to cap their downside exposure and for opening up larger potential profits than may be possible through traditional shares trading. Private investors are now increasingly using CFDs in a similar way, which has led to them becoming one of the world’s fastest growing ways to trade the financial markets.*

Contracts for Difference were once only available to major institutions. Private investors are now taking advantage of the opportunities this product offers. Used with prudence a CFD can be a wonderful tool for investors to maximise returns from a small initial outlay.

* CMC Markets UK Plc, July 2008

An Example

Here is an example of a CFD trader. Supposing that the minimum margin requirement for FTSE 100 shares at IG Markets is 3% – if a trader bought 10,000 CFDs of Vodafone at a price of £1.50, they would need a minimum of £450 in their account in order to open the trade ([10,000 x £1.50] x 3% = £450) as opposed to £15,000 had they bought the 10,000 stocks via a traditional stock broker.

CFD Examples

Imagine the physical purchase of 1,000 Barclays shares at 200p each. By investing the same amount of capital, you could buy a CFD representing 10,000 shares.

After 5 days you sell at a profit. Your selling price is 220p per share. Your deposit is returned to you, together with your profit.

This outcome assumes a favourable result, however if Barclays shares had dropped the leverage effect would have magnified your losses.

A CFD is a contract of a standard quantity of a specific underlying financial asset, usually a listed share. Usually, this means that one CFD contract is equal to one underlying share.

Simplified CFD Index Example

Here’s how a simplified CFD long trade might work, disregarding financing interest and any commissions:

An investor notes the FTSE 100 at 5,900 and thinks it has further to rise.

The CFD provider’s quote is 5,899-5,901
Buy to open at 5,901
The trader commits to one contract
Value of investment (£1 x index value): £5,901
Margin of 1%: £59.01

A week later the index has risen to 6,000
The CFD provider’s quote is 5,999-6,001
Sell to close at 5,999
Value of investment: £5,999
Trading profit (£5,999 minus £5,901): £98
Profit margin on funds deposited (£98 ÷ £59): 66%

If used carefully CFDs need not be money pits. They’re speculative trading opportunities. They’re not contracts for difference, but contracts which can make a difference.