Defaqto

What is a Contract for Difference?

A contact for difference (CFD) is a contract to buy or sell a share, or other asset, at a future date.

When you enter into a CFD you can either go ‘long’ or ‘short.’  If you believe the stock is going to rise ( ie you go long), you pay an amount at the end of the contract that equates to the asset's price at the time you entered the agreement contract, minus the price when the contract ends.

If the price rises, as you expect, then the difference will be negative, and when you close the contract you will make a profit.

Typically, a CFD requires an upfront payment of 10-20 per cent of the market price of the asset at the time of purchase. Because this initial payment represents a small percentage of the value of the contract, a CFD is known as a ‘margin’ product, and when you buy a CFD, you are said to be trading ‘on the margin.’

How it works

Assume you are an optimist, and you have heard a whisper that ‘The Great Growth Company is likely to see its share price rise in value, and that acting on this rumour, you take on a CFD, and ‘go long.’

When you agree to such a contract, you buy a certain number of units. Because you are trading at the margin, the money you pay up front is effectively a deposit. If you make a profit, this is refundable, and profit is in addition to this.

If you make a loss, your initial outlay will go towards the cost of this loss.

For example, assume your initial deposit is 10 per cent of the asset's value. When the contract ends your profit will be the price at the time the contract was signed, minus the price when it ends, times the number of units.

So if you agree to buy 1,000 units, with a unit price at the start of the contract of £10, you will pay 10 per cent of 10 x 1,000, or £1,000.

Assume that when the contract ends, the unit price of the asset is £12, so that the initial price, minus the final price, equates to - £2,000 units, which is your profit, less dealing charges (even though your initial outlay was only £1,000).

As the above example shows, the profits can be dramatic, but the losses can be too. If you get it wrong, and the share price falls, you could end up seriously out of pocket. So, taking the example above, assuming instead that your 1,000 shares fall to £8. Your loss will be £2,000 and you will have to pay out £1,000, on top of the £1,000 you have already paid upfront.

Open ended CFDs

One of the more interesting features of CFDs is that these contracts are open ended. You can choose to end the contract, whenever you want.

So if the asset moves in the opposite direction to what you had expected, you can either hang on to the asset, and wait for the price to move in the direction you had anticipated, or close out of the deal.

If you hang onto it, your broker will charge on a daily basis for this facility, (known as a margin call) so the longer you leave the contract open, the higher the charges. The danger is that the asset continues to fall in value and the longer you leave it, the higher the margin calls.

Shorting

When trading CFDs, it is always wise to ensure you have cash set aside in case you make a substantial loss. While you typically only have to shell out 10 to 20 per cent of the asset's value up front, you really need to set aside a lot more, in case the shares plummet in value.

If you have a pessimistic view on the likely movement of a share, you can enter into a CFD to sell a share in the future.  In this case, you pay the difference between the asset's price at the time the contract ends, and the asset's  price at the time the contract was taken out. stock in the future, or ‘go short.’

So returning to the example above, but this time applied to a ‘short’ CFD, you buy a CFD to sell 1,000 units in the future. Assuming that the current price of that asset is £10, and you are required to deposit 10 per cent of the asset's initial value, so this would be £1,000.

But with this type of CFD, you are committed to paying the price of the asset at the time the contract ends, minus the price at the outset times the number of shares.

Assuming the asset's value falls to £8, you pay £8 minus £10 x 1,000 units, you owe your broker -£2,000 (ie a negative amount), so you have effectively made a £2,000 profit, less dealing charges. So your broker has to pay you back £3,000 (£2,000 profit, plus your £1,000 upfront margin payment).

But, as in the example earlier relating to a long CFD, if you get is wrong, and the asset rises in price, you could make an equally substantial loss.

Interesting features

One of the major attractions of trading CFDs is that, unlike with share dealing, you don’t incur stamp duty.

Another attraction is that if you go long, and the company whose shares you have contracted to buy pays out dividends, you still receive these, just as if you had actually bought the shares.

CFDs carry another, less known, benefit. They are anonymous instruments, so you can go long, or short on a company without anyone knowing who the underlying buyer is.

You can even use CFDs to push a share price up, or down. An example of this was when Philip Green was bidding for Marks & Spencer. The share price went up, without investors knowing who the buyer was, although his identity was eventually revealed.

On the downside, CFD trading, unlike spread betting, is liable to capital gains tax. But the capital gains tax cloud has a silver lining - of sorts. If you make a loss, you can offset these losses against other gains.

So in a way, you can use the fact these instruments are liable to capital gains tax as a way to hedge against your investment. Making a loss is disappointing, but at least you can use this loss to reduce capital gains you have made elsewhere.

Top tips for CFD traders

So while CFDs offer potentially big rewards, they can result in huge losses too as some private equity firms and hedge funds have found to their cost. So what should you do to ensure you avoid the pitfalls?

• Don't be afraid to cut your losses. Holding onto a losing stock, hoping it will go up, will rack up huge losses and generate further margin calls;
•  If you make a series of losses, don't try to get your money back in one go, by taking a big risk. This can results in losses just getting bigger.
•  Equally it can be a mistake to sell too soon when a stock rises. Many investors make this classic mistake.
• Don't fall into the trap of thinking the market is against you, or with you. Keep your investments rational.
•  Don't rely on expensive software, especially if there's a danger you are not using it properly. The software may not even be all it’s cracked up to be.
• If possible, base you decisions to buy or sell on more than one factor.

CFDs versus spread betting

Who offers CFDs?

Firms offering CFDs include:

• Cannon Bridge Corporation
• Cantor Index CFDs
• City Markets
• Deal4free.com
• GNI Touch
• Halewood International Futures
• Hargreaves Lansdown
• IFX Limited
• IG Markets
• Kyte Clients
• Man Financial
• Saxo Bank
• Sucden Equity CFDs