“It is a fairly safe principle of investing that the harder a company is pushing you to do something, the more that’s in it for them - and the less for you,” says Dan Oakey in the Investors Chronicle. And for many, contracts for difference (CFDs) will fall into this category, given the eagerness with which brokers have been pushing them. But the truth is that CFDs really are “simple and transparent financial instruments that give you many of the benefits of an equity without some of the costs”.
Basically, a CFD is an equity trade made with borrowed money, says Investing for Growth. You put down a deposit with the broker (usually to the value of about 10% of the trade; this is known as the ‘margin’, see page 35) and borrow the remainder needed for the deal from him. He then buys the shares and enters into a contract with you that entitles you to receive any upside (or be liable for any downside) in the price. You can close the position at any time and the profit (or loss) comes from the difference between the contract’s opening and closing value (the contract value being the number of shares specified, multiplied by the market unit price). This system gives you exposure to shares without you actually having to buy them (so there’s no stamp duty to pay); it also gives you significant leverage.
Think of it as you would a mortgage. If you were to buy a house for £500,000, you might put down a deposit of £50,000 and borrow £450,000. If the value of the house rises 10% to £550,000, the value of your equity will have gone up not by 10%, but by 100%. If you sell the house now, you get back £100,000. It’s the same with a CFD, says David Harris in What Investment. Let’s say you think shares in a particular firm will rise. You take out a CFD to buy 1,000 shares at £1. That makes the total value of the contract £10,000, but you will only be required to put down a margin of 10% (£1,000). If the price then rises to £1.05 and you close the contract, you get back your deposit plus a profit of £500 (5p x 10,000). But the joy of CFDs is that they can also be used to replicate leveraged short positions, says Harris. If you think a particular share will fall, you could take out a CFD to sell 10,000 shares at £1. The contract value is £10,000, but again you put down only 10%. Say the shares then fall to 90p. You get back the £1,000, plus another £1,000 (10p x 10,000).
This all sounds simple, says Ceri Jones in Money Observer, but there are complications. When you go long on a CFD, you are borrowing the money you need to trade and this means financing costs. The broker will charge you interest (the rate is typically the London Interbank Offered Rate, or Libor, plus 2-3%). and this means that if you hold a position for too long, the interest payments could cost you more than stamp duty would have. But if you run a short position, you will receive interest on the money raised by selling the shares on your behalf: even if the shares in your contract don’t move, you will still make money.
And consider the effect of leverage. It’s fine when prices are going your way, but when they aren’t your losses can get nasty. In the long example above, if the shares had fallen to 95p you would have lost £500 and only got £500 of your deposit back: the shares have lost 5% but you are down 50%. Worse, “the real drag” of CFD trading is that if your position goes against you, you have to keep depositing extra margin on a daily basis - you can’t just sit on paper losses. But you can, and should, set stop-losses to limit the damage: decide how much of a loss you can bear and arrange for the contract to be closed if it hits that level.
Five good ways to use CFDs
Gear up: Before brokers let you open a CFD account, they have to establish that you have enough experience of trading to be up to it, says Dan Oakey in the Investors Chronicle. And for good reason: given that most brokers allow you to put down a deposit of only 10% - ie, to ‘gear up’ ten times - the potential for amateurs to lose money is huge. Experts might, however, want to look at CFDs on currencies and indices where brokers may allow more aggressive margins of 7.5%. Deal4Free even offers margins of 1%. That means you can borrow 100 times your original stake.
Speculate on sectors: There are few obvious ways to speculate on the US market’s various sectors, says Oakey. Exchange traded funds are only offered on the most popular sectors and even then only on a pan-European basis. However, CFD brokers City Index, Deal4Free and IG Markets all offer products built around sectors such as software, insurance or pharmaceuticals. In volatile sectors, this can offer interesting trading opportunities.
Plan your taxes better: Bed and breakfasting, where you sell shares and buy them back the next day to crystallise losses or gains for tax purposes, was outlawed in 1998. Now if you sell you have to wait for 30 days before buying again and in that time the market could move against you. The solution? Use CFDs to gain exposure to the relevant shares during that month. Likewise, if you own an Aim share and believe that a short-term correction is likely but are loath to make a physical sale and hence lose your taper relief on future gains, you could use a CFD to go short in the short term, hence neutralising any loss on your physical holding, says Growth Company Investor.
Hedge yourself: If you have a broad-based portfolio of shares that mirror the index, you could sell index CFDs to hedge your investments, says Oakey. But bear in mind that the broker will be covering his position by buying or selling FTSE futures. He will pass the cost of that on to you in his spread, so you may well be better off dealing in futures directly.
Dividend surf: CFDs give you the advantages of investing in equities without the inconveniences, says Oakey. So if you are long a CFD on the day the underlying shares go ex-dividend, you get the dividend. In theory, this should “all come out in the wash” as the shares should fall back by the amount paid out in dividend. But this doesn’t always happen - stocks with good momentum often don’t fall by the full amount. So a trader who jumps in, banks the dividend and bails out before the share price “fully settles down” can often make a tidy profit.
You can compare leading CFD accounts here.