Contracts for Difference Guide

Contracts for difference (CFDs) were launched in the late 1990s, since when usage of these contracts by both retail and institutional investors has grown to around 50 per cent of total share trading.

This phenomenal growth is hardly surprising given the considerable attractions of CFDs, including the lack of stamp duty, the facility to gear up, and the anonymity that they provide in that share ownership via CFDs does not have to be declared to the London Stock Exchange.

Use the links below to move to the section you want to read:

• How it works
• Open ended CFDs
• Margin trading
• Interesting features
• Top tips for CFD traders
• Who offers CFDs?

Gearing

We hear a lot about geared investments these days. Private equity, for example, has enjoyed phenomenal growth and has generated big rewards for private equity firms, often employing large amounts of borrowing, or gearing.

The buy-to-let market is all about gearing, too. Buy to let landlords can invest in a property and enjoy growth in the property market by only having to put down a small deposit. The remainder, or gearing, comes in the form of a mortgage.

So it is with CFDs. The investor usually only pays upfront for a small percentage of the asset invested in. For example, assume that by gearing, you only pay for 10 per cent of an investment, and this increases in value by 10 cent. Your initial investment, less dealing charges, has doubled in value.

Justin Modray of IFA firm, Bestinvest, explains: “Say you invest £1,000 in 10 shares costing £100 each, but with no gearing. If the share price rises to 120p, your profit is £200.

“But if you geared up, the same £1,000 could enable you to buy £5,000’s worth, or 50 shares, of the same company’s shares, using gearing via a CFD, so if the share price rises to 120p, your profit is £1,000. This is because the CFD provider normally only requires you to invest an initial margin, usually 20 per cent of the value of the underlying shares, in this case £1,000.”

That said, geared investment of any type also carries considerable risk. If you get the call wrong, you could lose a disproportionately high percentage of your initial investment.

What is a Contract for Difference?

A contact for difference (CFD) is a contract to buy or sell a share, or sometimes other investment type, 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 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 the investor who takes out a CFD is 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.

The amount you pay up front is normally 10-20 per cent of the investment’s initial value. So for example, assume your initial deposit is 10 per cent of the asset's value. When the contract ends your profit will be 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 outset of the contract of £10, you will fork out 10 per cent of 10 times 1,000, which equates to £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. 1,000 units were bought, so your profit is £2,000, minus dealing charges. So, in the case of this example, (and ignoring dealing charges,) you will have made a £2,000 profit, from an initial outlay of £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 the share prices falls to £8. Your loss will be £2,000 and you will have to pay out £1,000, on top of the £1,000 you 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, as and when you feel the time is right.

So if the asset moves in the opposite direction from what you had expected, you can hang on to the asset, and wait for the price to move in the direction you had anticipated before you close the contract.

However, your broker will usually charge on a daily basis for this facility, so the longer you leave the contract open, the higher the charges. The danger is that the asset falls in price when you had expected it to rise, and so you wait. While doing so, the charges continue rise.

If the price falls very low, your broker may want you to deposit more money, so that he has greater cover for the potential loss. For you, it's difficult to know when to get out and the temptation is to wait, even though the danger is that by doing so you simply compound your loss.

Margin trading

Another point to remember is this. If you have taken out a CFD, it is always wise to ensure you have cash set aside in case you make a substantial loss. So while you may typically only invest 10 to 20 per cent of the asset's value, you really need to set aside a lot more than that, in case the worst happens.

But a CFD can also work the other way. If you have a pessimistic view on the likely movement of a share, you can enter into a CFD to sell a stock, or ‘go short.’ 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.

So returning to the example above, but this time applied to a ‘short’ CFD, you agree 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, you deposit £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.

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 the £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 attractions of CFDs is that, unlike share dealing, they don’t incur stamp duty. Hedge fund managers, in particular, like this feature, which is part of the reason why they are a popular instrument with these funds.

If you take a long position, then if the company whose shares you have contracted to buy, pays out dividends, then you get paid the dividends, just as if you had bought the shares.

However, CFDs, unlike spread betting, are eligible for capital gains tax. But the capital gains tax cloud has a silver lining - of sorts. If you make a loss, you can use this as an offset 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.

For heavyweight investors, like hedge funds, CFDs bring another benefit. They are anonymous instruments, so you can go long, or short on a company without anyone knowing who you are.

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

Top tips for CFD traders

So while CFDs offer potentially big rewards, they can result in huge losses too. So what should you do to ensure you are as successful as possible?

• Don't be afraid to cut your losses. Holding onto a losing stock, hoping it will go up, will rack up huge losses.
• 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

Last edited August 2007

© Find.co.uk