Cfd Trading: A Way Of Trading On The Stock Market Without Buying Shares

A CFD (Contract for Difference) is an over the counter agreement between two parties

to exchange the difference between the opening and the closing price of that contract at the close of the contract based on the underlying share multiplied by the number of shares specified in the contract. Sounds complicated, but it's not really. Institutions and hedge funds have utilised CFDs for more than ten years in the UK stock market as an alternative means of investment to traditional stocks and shares. CFD trading is similar in many ways to spread betting in that both are margined products so you can 'gear yourself up' or take a position that is a multiple of your available funds.

If, for example, the margin on a firm you're interested in was 10 per cent, establishing a position of GBP100,000 would only require a deposit of GBP10,000. Any running profits you make can be used as margin to establish new positions but any running losses would have to be made good by reducing your position or providing additional funds.

While stamp duty of 0.5 per cent on all UK share purchases has in the opinion of some traders reduced the cost effectiveness of 'day-trading' traditional stocks and shares, both CFDs and spread betting are exempt and this has added to their appeal. CFDs are liable to capital gains tax whereas spread bets are tax free, but losses incurred from spread bets are gone for good while CFD losses can be offset against future profits for tax purposes. When you trade in CFDs, you purchase those contracts in almost the same way that you'd buy shares. So if you wanted exposure to 1,000 shares in a company, you'd have to sell 1,000 contracts at, say, 494p per contract rather than simply placing a GBP10 per point bet with spread betting to get a similar return.

The other difference between the two instruments lies in the flexibility in the bid-offer spread. Most CFD providers allow you to post orders anywhere within the bid-offer spread whereas spread betting firms post their own two-way take it or leave it price exactly as a bookie would. With CFD you are the price maker, which is why hedge funds tend to use CFDs rather than spread betting. CFDs do not wrap the costs of financing a position within the spread (as does spread betting) but charge those costs and commissions separately. Because of this, the CFD spread quote will always be very close to the underlying price of the share or commodity that you are following. CFD's also mimic almost every aspect of actually owning the underlying share or market, so if you hold a position long enough, you receive the benefit of any dividends being paid on the underlying shares.

CFDs and spread betting have particular features that will appeal to different trading styles and there is no one 'best instrument' to use. Although they should not be regarded as substitutes for long term investment or saving, as more people seek to take control of their financial destiny, there's been a growing realization that 'going short' is a legitimate means of trading in market that's become increasingly difficult to profit from in a traditional sense.

by: Tom Hawkins

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