What is a CFD and how does it work?
What does CFD stand for?
CFD stands for Contracts for Difference.
What is a CFD?
They are similar to the normal purchase of shares/investments, however rather than having to pay for the investment outright, you are lent a significant portion of the investment by the CFD provider (in a similar way to spread betting).
CFDs are often used to hedge existing positions and according to some sources trading in CFDs for hedging account for circa 30% of trading volumes on the LSE. Due to its hedging capabilities the CFD market probable most resembles the futures and options markets.
How does a CFD work?
As usual, this is best explained with an example (ignoring commissions for now):
You have £500, and want to speculate on an individual stock trading at £50.
If you were to purchase these shares outright, you would be given 10 shares. If the share price goes up to £55, your investment is worth £550 (10 shares x £55), leaving you with a profit of £50.
If you purchase a CFD, you only required to invest an initial margin (usually between 10% and 20% of the value of the underlying shares. So in the example above, if the margin is 10%, you would be able to purchase £5,000 worth of shares (i.e. 100 shares) rather than just 10. Now if the share price rises to £55, then your holding is now worth £5,500 from a £500 investment – which is a 100% return. Bear in mind that things can go in the other direction, so you could lose the same amount if the share price goes the other way.
CFDs have many similarities to spread betting. Both are leveraged investing, and both enable you to go long or short. However the key difference between spread betting and CFDs, is that unlike spread betting, CFDs are not considered gambling, and therefore although CFDs are exempt from Stamp duty, they are subject to capital gains tax in the UK and Ireland.
At first glance, this may seem like only a disadvantage versus spread betting, however it actually can work both ways, because losses incurred trading CFDs can be offset against future profits for capital gains tax purposes. This may be relevant if you are using short trades to hedge a long position, and therefore, if your long position is successful, you can benefit from using the losses on the short position to offset some of your capital gains.
Excluding the tax treatment, there is not a great deal of difference between the two products - this was what led many CFD providers to enter the spread trading market in the early 2000s.
Finally, there are slight differences in the way the products are traded, that might cause you to choose one over the other, since CFDs are traded in a similar style to traditional shares trading (so if that is your background, you may prefer this familiar approach), whereas spread bets are based around buy and selling points.